Bonds are commonly touted as a safe form of investment, especially for newcomers that want stable returns. However, not all bonds are the same and no investment is 100% risk-free.
If you’re looking to get into bonds in 2018, here’s a closer look at why they’re considered safe, without brushing over the very real risks …
Safer than Stocks
Stocks and bonds are often discussed in the same breath, but the key difference is underlying debt and equity.
If you buy a bond you are essentially lending the issuer money that they agree to pay back at the maturity date, as well as regular interest. Buying stock in a company means you hold equity and are a percentage owner of that company.
Bondholders make a fixed-income investment. They are legally entitled to get back what is agreed. Shareholders are investing in the success of a company and are not protected if that company fails. They might see bigger returns if it takes off, but they’re also at higher risk if it fails.
If a company goes bankrupt bondholders and other creditors are the first to be paid what they’re owed, while shareholders go down with the ship.
Bonds are considered a safe investment because they generate a predictable and stable income. In fact, you get the same return whether the company is having a record year of profitability or close to collapse. The trade-off is that the returns are much lower than the potential returns from other types of investment.
A typical bond entitles you to the return of the principal at the maturity date, as well as regular coupon payments (think of this as interest).
However, these interest rates are typically higher than a savings account at the bank, making bonds the next logical step for your financial portfolio after building up some regular savings.
Because of this stability, bonds are often favored by people saving for retirement or those wanting to build a foundation before moving into riskier types of investment.
Not All Bonds are Made Equal
It’s worth noting that not all bonds are the same. Often when people talk about bonds they’re actually referring to treasury bonds issued by the US Government. These are the safest type of bond (it’s extremely unlikely that the Treasury will go bankrupt), but they also offer the lowest interest rate, (a 30-year bond might only yield 3%).
Treasury bonds are an ideal long-term investment and a good alternative to a bank savings account.
A similar but riskier investment is in municipality bonds—bonds issued by the local government like Florida state, to fund its spending. In essence, the government is taking out loans with the public.
Companies also issue bonds to raise finance without giving up any ownership (as with stocks and shares). These are riskier than Treasury bonds because companies can and do go out of business, though bondholders are front of the line if that happens.
Junk bonds are the riskiest type of bond and are usually issued by companies seeking to finance a takeover. There is no guarantee that the takeover will happen or that the company will succeed if it does.
Changes in interest rates are one of the main risks of bonds. If interest rates are on the rise, the value of your bond will drop. That’s only if you wish to sell it on. If you keep it, you’ll simply be stuck with a lower interest rate than anyone buying new bonds at the higher rate.
If interest rates drop, your bond will be comparatively worth more.
Credit risk is the risk that the bond issuer will default and will be unable to pay you back when the bond matures. This will almost never happen with US treasury bonds but could happen if you have bonds with struggling companies or even municipalities.
That being said, the risk is still generally lower than holding stock in a company or speculating on the market.
Ultimately, while bonds are certainly a low-risk investment and can form a stable foundation for your portfolio in 2018, it is important to recognize that there are never any guarantees.
Are you invested in bonds? Let us know your experiences in the comments below!