Gains from investing in bonds

UDEME EKWERE writes on some advantages to be enjoyed from investment in bonds

Investments in capital and money market instruments is not all about shares and stocks, as bonds are also a veritable option which business owners and individuals can explore.

Although it is generally believed that stocks earn higher returns than bonds, market analysts advise that for one to have a richer portfolio, investment in bonds is a necessity.

Experts say that although there are various misconceptions about bonds, the fact remains that these instruments can contribute an element of stability to almost any portfolio.

Bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are great savings vehicles when you don’t want to put your money at risk.

The Chief Executive Officer, High Cap Securities, Mr. David Adonri, says that usually because of their low-risk nature, investors sometimes feel safer with bonds rather than stocks despite their lower returns.

He explains that there are several reasons why business owners and investors should consider putting some of their funds in bonds. Some of these reasons are:

Diversification

Bonds tend to be less volatile than stocks and can therefore stabilise the value of your portfolio during times when the stock market struggles.

Experts say that having a combination of both types of investments over the long term can often provide comparable returns with less risk than a portfolio devoted to only one type of investment.

Stability and lower taxes

If investors know they will need access to large sums of money in the near future, for instance, to pay for college, a home, or others, then it does not make sense to place that money in a highly volatile investment like stocks.

Also, payments from some bonds are exempted from federal taxes. For individuals in high tax brackets, these investments are often an excellent vehicle for their portfolio.

Consistent income

Unlike stock dividends, coupon payments are consistently distributed at regular intervals. Individuals seeking this consistent income might find bonds a better alternative than the dividend payments some stocks offer.

Adonri says, “You will notice that some companies have challenges in a particular fiscal year and this could stop them from making necessary dividend payments in that year in the case of stocks, but this is not the same story for bonds.

“Therefore, those who invest in bonds stand greater chance in terms of consistent income, compared to what they could get from investing in stocks.”

There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market.

According to experts, by owning bonds, retirees are able to predict with a greater degree of certainty how much income they’ll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.

Better than the bank

Sometimes, bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts.

As a result, if you are saving and you don’t need the money in the short term, bonds will give you a relatively better return without posing too much risk.

However, experts note that investment in bonds, like any other money market instrument, is not usually risk free.

The following are some risks associated with his kind of investment, and it is important for investors to take note of them.

Interest rate risk

Bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease. The interest rate on a bond is set at the time it is issued.

Generally, the coupon will reflect interest rates at the time of issuance. However, if interest rates increase, people will be unwilling to purchase the bonds in the secondary market at the earlier rate.

For example, if the coupon is set at six per cent and interest rates in the market are at seven per cent, the interest rate on the bond is well below what you could get from a different investment.

Therefore, the price of the bond will decrease so that the capital appreciation will make up for the difference in interest rates. (For this reason, it can be risky to buy long-term bonds during periods of low interest rates.)

Credit risk – Just as individuals occasionally default on their loans or mortgages, some organisations that issue bonds occasionally default on their obligations. If this is the case, the remaining value of your investment can be lost.

Call risk – Some bonds can be called by the company that issued them. That means the bonds have to be redeemed by the bond holder, usually so that the issuer can issue new bonds at a lower interest rate.

This forces you to reinvest the principal sooner than expected, usually at a lower interest rate. This subject will be further discussed in later sections.

Inflation risk – With few exceptions, the interest rate on your bond is set when it is issued, as is the principal that will be returned at maturity. If there is significant inflation over the time you held the bond, the real value (what you can purchase with the income) of your investment will suffer.