Pros and Cons of Bond Investment
Have you ever looked at the pros and cons of investing in bonds. Yes, bonds investment has some advantages and some disadvantages too. There are some benefits like the bond interest rates are fixed and so they are more predictable and reliable. Also there are specific categories like tax-free bonds which enhance post-tax yields.
Bonds also offer a wide choice. There are safe gilt edged bonds issued by the government and at the other end, you have high yield bonds that are bordering on junk but give high returns. Among the other bond benefits is diversification of risk. Here is a quick look at the advantages of bonds for investors as well as the pros and cons of bonds.
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First a look at the advantages of investing in bonds
Bonds are considered one of the safest investment options and not only give stable returns and capital growth but also ensure that the capital is protected from downside risk. Here are some of the major benefits of investing in bonds.
• Bond’s provide fixed returns and assured returns to investors. Just contrast these bonds with equities. Your equity investment can go up 20% or even go down 30% in the next one year. That makes it highly unpredictable. While equities are essential for wealth creation, you obviously yearn for some degree of stability and predictability. You need an investment avenue where you can put your money and accurately predict what it will grow to over a period of time.
• Bonds are also flexible on the interest payment options. For instance, you have bonds paying annual interest, semi-annual interest, quarterly interest or even monthly interest. You can also entirely eliminate your reinvestment risk by opting for deep discount bonds or zero coupon bonds where your interest is accumulated and repaid as a lump sum at the end of the bond tenure. It suits a lot of people with specific needs.
• Remember bonds are much lower on the risk scale, although the returns may not appear to be too exciting. It is not just about predictable rate of return but also that investors can eliminate as much risk as possible in the process. Not surprisingly, bonds turn out to be the safest investment option available.
• At the end of the day, the bonds are a form of debt, meaning that the bond issuer has a legal obligation to repay bondholders. You cannot just default on payments and there are legal consequences to that. Also, issuers don’t default on bonds as it would pull down their credit rating and making it tough for them to survive in the bond borrowing market in the future. There is too much at stake and it behoves upon them to repay such pay-outs well on time.
• Bond holders have a precedence over equity holders in the event of liquidation since they are debt holders and not owners, unlike equity shareholders. While, they may still take a haircut, they will not lose the entire capital like most of the equity investors end up losing.
• Investing in bonds is a lot better than letting money idle in your bank checking accounts. Yields are higher and risks are fairly even stevens. In India, savings accounts provide just 4% interest and that too on the minimum balance. On the other hand, the bonds give you a fixed return of 6% to 8% and that makes them a lot more attractive in comparison. Here you need to understand that it does not make sense taking on too much risk in bonds because ultimately the bonds are fixed rate instruments. Some of the high yield bonds give very good returns, but they also come with default risk of a high order.
• There is a legitimate rating system for bonds which makes their default risk measurable and investors can act accordingly. While stocks are not rated based on their risk, bonds are universally rated by agencies like Moody’s, Standard & Poor and Fitch based on some clearly defined risk factors. Thus investors have a very clear understanding of exactly how much risk you must take when purchasing a bond. Normally, higher rated bonds earn lower returns while lower rated bonds earn higher returns. The advantage is that there is a clear numerical classification and investors can make a conscious choice.
A look at some of the disadvantages of investing in bonds
It is not roses all the way when you invest in bonds. There are some disadvantages too. While bonds offer a steady, reliable return on investment with minimal risk; here are some downside risks that you need to be aware of about bond investing.
• Yields on bonds are much lower than stocks and do not create wealth over the long term. If you are looking at goals like retirement or children’s education over the long term, it makes a lot more sense to focus on equity investing than on bond investing. Normally, it is investors who cannot stomach the volatility of other instruments that tend to invest in bonds. Stocks do not give any guarantee, but in India even an equity mutual funds returns 14% to 15% annualized over a longer period of 10 years or so. That is the kind of returns that bonds can never match.
• Bond investing is normally a big investor’s game. To make some meaningful returns on bonds, you need to make big investments and it is more of an HNI product or an institutional product, than a retail product. This puts bonds out of reach of most investors, unlike equities which people can participate even with small principal.
• Theoretically, bonds are safe, but bond defaults have occurred and will continue to occur, especially in the case of high risk bonds. In India, we have seen major groups like the Essel group, ADAG group and Future group default on their bonds. One can argue that bonds are more secure than stocks in the event of a bankruptcy, but then you normally don’t invest assuming that the company would go bankrupt. Investing is always about optimism and not about pessimism.
• Liquidity is a major issue and quite often bonds are less liquid than stocks. With demat and a proliferation of demat accounts, equities have become a lot more liquid compared to bonds, which still are traded thinly in the secondary markets. That creates a problem since the bonds are locked in for a longer period of time. In case you need liquid cash at short notice, equities can offer a better option even when you consider price risk.
• The biggest risk in bonds is the interest rate risk and you must never forget that. Interest rate risk or the price risk is the risk that the prices of the bond will go down if the interest rates go up. Plus there is the opportunity loss that he is stuck into a low paying and low yielding bond. Normally, this risk is more pronounced for long duration bonds than for short duration bonds.
• Finally, there is call risk or prepayment risk in bonds. Many bonds have call feature and companies will exercise this option if rates fall too sharply. That way they can refinance bonds at a lower rate. However, it does leave investors in a lurch and that is a big risk.
Yes, bonds have some benefits but come with risks too. It still makes sense to add bonds to your overall investment portfolio for the sake of stability and assurance.
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