Fixed income investments (bonds) pay a fixed interest rate over a given time period and then return the investor’s principal. Bonds are used by companies and governments to raise money by borrowing from investors. The basic features of a bond are:
- Principal – The face value of the bond. The bondholder is repaid his principal in full when the bond matures.
- Maturity – Bond maturities can range anywhere from a one day to 30 years. Bonds with maturities of less than a year are generally known as money market instruments.
- Coupon – The coupon is the interest rate that is paid to the bondholder. The interest is usually fixed and paid semi-annually or annually.
Bonds are also rated from AAA (highest grade) to C based on their credit worthiness. AAA bonds are perceived to have little risk of default and its issuers have a very strong capacity to meet is financial obligations. Junks bonds (BB and lower), on the other hand, have higher default risks and offer much higher yields as investors expect a higher return for the increased risk.
A bond’s market price (which is different from its face value) is also affected by prevailing interest rates. Bond prices have an inverse relationship with interest rates — prices fall as interest rates increase as investors have more opportunities to generate higher yields elsewhere. Similarly, bond prices increase as interest rates fall as the bond’s coupon rate becomes more attractive compared to interests rates elsewhere.
- Investment returns are fixed. You receive a fixed rate of interest and your principal returned when the bond matures. You know exactly how much your returns will be.
- Less risky compared to stocks. Besides receiving specified investment returns, bondholders are paid first over shareholders in the event of liquidation.
- Less volatile. A bond’s value can fluctuate according to current interest and inflation rates but are generally more stable compared to stocks.
- Bonds have clear ratings. Unlike stocks, bonds are universally rated by credit rating agencies like Standard & Poor’s and Moody’s. This gives investors more assurance when picking a bond but you probably still want to conduct your own research and due diligence before investing.
- Investment returns are fixed. While this offers higher safety for investors, it is also a disadvantage as you forgo the higher potential gains if you invested in equity.
- Larger sum of investment needed. While some bonds can be purchased for relatively low sums ($1,000), some bonds may require larger amounts which may put them out of reach for some investors.
- Less liquid compared to stocks. Some bonds may be highly liquid like those issued from the US Treasury and major corporations, but bonds issued by a smaller, less financially stable company may be less liquid as there are fewer people willing to buy them. Bonds with a very high face values will also be less liquid as the pool of potential buyers is smaller.
- Direct exposure to interest rate risk. Interest rates affect the value of bonds more directly compared to stocks. If you plan on just receiving interest payments and holding the bond to maturity, this might not concern you. But otherwise, bondholders are more exposed to interest rate risk.
Read the Full Series:
The Pros & Cons of Investing in Stocks
The Pros & Cons of Investing in Bonds
The Pros & Cons of Investing in the Money Market
The Pros & Cons of Investing in Real Estate
The Pros & Cons of Investing in Commodities