Bonds are one the most common investment options both for first-time investors and seasoned ones. They have notable advantages over the money market and stocks. However, they also have drawbacks or disadvantages when compared to other investment options. This article outlines the advantages and disadvantages or pros and cons of investing in bonds.
Pros: Advantages of Investing in Bonds
Note that bonds are one of the common forms of securities and are also referred to as debt instruments that fall under the general category of fixed-income instruments. They represent loans or debts provided by investors or debtholders to borrowers. The following are the advantages of investing in this instrument:
• Fixed-Income Through Interests: One of the advantages of bonds is that they provide fixed income through the interests of the loaned amount or principal. An investor has a better idea of how much his or her investment returns will be. Bondholders also receive back their principal once their bonds matured.
• Less Risk and Less Volatile: Bondholders are paid first over shareholders in case a particular company closes and liquidates. The value of a bond can fluctuate based on prevailing interest and inflation but they are still less volatile than stocks. They are ideal for individuals with moderate risk profiles.
• Information Through Ratings: Another advantage of bonds is that they are rated by reliable credit rating agencies. AAA bonds have less risk while junk bonds or those with BB or lower ratings have higher default risks. These ratings provide investors with relevant information as regards the risks attached to relevant bonds.
• Diversity Due to Different Options: There are different types of bonds. The most common ones are corporate and government bonds. The availability of these options enables investors to create and maintain a diversified investment portfolio. Note that there are different selections of corporate bonds alone.
• Wealth Preservation Vehicle: The lower volatility of bonds also makes them an ideal investment option for individuals who want to preserve their wealth or lessen the tendency of their investments to lose value due to market disruptions. Remember that bondholders will get back their principal once their bonds matured.
Cons: Disadvantages of Investing in Bonds
Most of the disadvantages of bonds become more pronounced when they are compared with the advantages of investing in stocks. The returns are not 100 percent guaranteed and there are also still some risks like most investment options. The following are the specific disadvantages or drawbacks of investing in bonds:
• Investment Returns are Fixed: Remember that bonds are fixed-income securities. This can be either an advantage or a disadvantage. The investment returns are expected unlike the potential future value of stocks and other aggressive investment options such as futures and contracts that can provide higher and better returns.
• Lower Risk Means Lower Returns: The risk-return trade-off states that with higher investment risk comes higher investment returns. The same concept also tells that with lower risk comes lower returns. Remember that bonds provide lower returns than stocks and other higher-risk investment options.
• Stocks Have Higher Historical Returns: It is also important to highlight that stocks tend to outperform bonds based on historical data from developed and developing countries. This is critical when the goal is to beat or outpace inflation. Of course, bonds offer more reliable albeit smaller returns.
• Interest Rate and Default Risks: Bondholders are exposed to several risks unique to bonds. Note that bond prices tend to go up when interest rates are high, as well as whenever the inflation rate is high. Furthermore, they also expose investors to credit or default risk, especially in the case of low-rated bonds.
• Less Liquid Compared to Stocks: It is also important to note that bonds are relatively liquid. However, they are less liquid compared with the money market investment options, as well as with stocks. Bonds issued by smaller companies or less stable institutions, as well as those with high face value, are likely to be less liquid.
A Note on the Pros and Cons of Bonds
The aforesaid disadvantages do not mean that one should avoid investing in bonds. Remember that it has notable advantages that allow investors to manage the risks associated with having a less diversified investment portfolio. It is also important to stress that investing in both stocks and bonds is essential both for diversification and in meeting complex financial and specific investment goals and objectives.
