Why Investors Use Bonds

Although high-rated bonds are considered one of the safer ways to invest your money, there are advantages and disadvantages you should take into account before making any decisions.

 

The following is a non-exhaustive list of such advantages and disadvantages.

Some advantages:

  • Income: bonds are designed to provide the investor with pre-determined fixed streams of income.  Bond issuers make coupon payments on a set schedule for a set amount. The redemption price and interest payments are established at issuance and do not change throughout the life of the security.
  • Diversification: an equity investor faces the risk of declining equity markets. Such investors may use bonds to compensate this risk, given that performance of equities and bonds often have an inverse relationship.
  • Protection: bonds which pay a fixed income can help protect investors against economic slowdown or deflation.  Inflation-linked bonds can also help them protect the purchasing power of their investments against inflation because their capital amount is tied to an inflation index defined at the issuance.
  • Capitalization: Zero coupon bonds allow investors to save money for long term goals, such as retirement. Structured with a deep discount, such instruments require a small initial investment designed to grow over years.

Some disadvantages:

  • Bankruptcy: companies (and sometimes even local governments) can go bankrupt and default on their loans. The only risk-free bonds are government bonds.
  • Early Repayment - Some bonds can be repaid early.  This is known as a bond being “called.”  If your bond is called you will still be repaid your initial investment as well as any interest you've earned so far, but you will not receive the future interest you would have otherwise gained.
  • As an example, let's say a 9% bond with a 10 year maturity is called after 6 years. You would be repaid your initial €10,000 investment (the principal), plus the €5,400 you had accumulated in interest. However, you would not receive the additional interest you were expecting when you made your initial investment for 10 years.
  • Most important, if the company decides to call a bond, chances are interest rates are lower.  You also may not be able to find a similarly rated bond that pays the same 9% interest you were receiving.
  • Rising Inflation - If inflation rises, the actual interest you make on your initial investment will be depreciated. If you decide to sell your bond in the market, in order to get a higher rate of return with another instrument, you are at risk of losing some part on the principal. Inflation-indexed bonds may help you prevent this risk.
  • Selling Before Maturity - If you decide to sell your bond before the maturity date, there is a risk you will receive less than you paid, depending on current interest rates. If interest rates climb, the value of your bond may go down.  On the contrary, when interest rates drop, a bond’s value soars. To avoid uncertainty, many individual investors prefer to hold their bonds until maturity. It may help to determine the timing of a financial goal in order to purchase a bond that matures at the same time.