The Pros and Cons of Buying Bonds

Pros of Buying Bonds

Investors use bonds in different ways depending on their goals, risk tolerance and current market conditions. But some of the benefits of bonds can make them a valuable addition to a diversified portfolio or investment strategy.

Regular Income That's Sometimes Tax-Free

Most bonds have a fixed coupon payment—the interest that bondholders receive—and you'll generally get a coupon payment every six months. The regular income can be helpful for investors who need the money for day-to-day expenses. Or, you can reinvest the earnings if you don't need the money right now.

Also, if you purchase municipal bonds from a local, city or state government, you often won't have to pay federal income taxes on the earnings. Depending on where you live, you also might be able to avoid local and state income taxes. Income from federal bonds is often exempt from local and state income taxes, but still taxed at the federal level.

Less Risky Than Stocks

Bonds tend to be less risky than stocks or equity funds. With federal bonds, you're lending money to the federal government. These are sometimes called risk-free investments—after all, the government has the power to print money—but there are examples of national governments defaulting on their debts. Local or state bonds might be a little riskier, but defaults are rare.

Corporate bonds can be riskier than government bonds, but lending a company money could still be safer than buying its stock. If you hold the bond to maturity, you'll receive your initial investment back plus the interest earnings. When you purchase a company's stock, you can lose money if the share price goes down. And if a company files for bankruptcy, bondholders often receive some of their investment back, while shareholders could be completely wiped out.

Relatively High Returns

You might be able to lock in higher bond yields than the current yield on most savings accounts, although some high-yield savings accounts might offer higher rates. Similarly, bonds might offer higher rates than some, but not all, certificates of deposit (CDs) with a similar maturity date.

In either case, there's a trade-off to consider. Even if you can get a higher rate with a high-yield savings account or high-yield CD, the savings account's rate can drop at any time and you might only be locking in the CD's rate for six months to a few years. Even if you receive a slightly lower rate on a 10- or 30-year bond, that might make more sense, especially if you're entering retirement and want to secure a steady income stream for the coming decades.

Cons of Buying Bonds

Relatively safe and steady investments can be attractive to some investors, but that doesn't mean buying a bond is always the right move. There are still risks involved, and you'll want to consider these when deciding how much to invest and which bonds to buy.

Values Drop When Interest Rates Rise

You can buy bonds when they're first issued or purchase existing bonds from bondholders on the secondary market. Generally, you buy bonds in increments of $1,000, and the bonds have a face value, or par value, of $1,000—the amount the bond issuer repays at maturity. However, a bond's value can change on the secondary market, which could impact your returns if you need or want to sell a bond before it matures.

The value will drop if interest rates increase. After all, someone won't want to pay you $1,000 for a bond that pays 4% when they can get a new bond that pays 5% instead. Conversely, if interest rates drop, your bond's value might increase. The effect of interest rate changes on a bond's value is also called interest rate or market risk.

Yields Might Not Keep Up With Inflation

Bondholders also need to consider inflation risk—the risk that rising prices will decrease the value of the fixed income you receive from the bond. Federal Trea sury bonds have 20- or 30-year terms, and even if inflation rates don't drastically climb, the compounding effect of inflation on prices can be significant over that period. It can be especially important to keep this in mind if you plan to rely on the income for your day-to-day expenses.

Some Bonds Can Be Called Early

You might not think of getting paid back early as a risk, but that's exactly what "call risk" describes. Many bonds are callable or redeemable, which means the bond issuer can repay the bond early. It's a risk because you'll no longer have a reliable income stream from the bond.

Often, this happens when interest rates fall. Although lower rates might increase your bond's value, the issuer isn't buying the bond from you—it's simply paying off the debt early. The bond issuer might turn around and issue a new bond for a lower rate to save money. But now you're stuck with the cash and likely can't find an equally safe way to earn the same amount of interest.

How to Decide if Buying Bonds Is Right for You

Many people decide to invest in bonds because they want to:

• Decrease their portfolio's overall risk by allocating a portion of their money to bonds instead of stocks
• Generate fixed income when they're near or in retirement
• Hold the bonds to maturity, or don't think interest rates will rise

As a general rule of thumb, some financial advisors suggest investing in a mix of stocks and bonds based on your age—your age represents the percentage of your portfolio that you invest in bonds. So, if you're 30 years old, 30% is in bonds and 70% is in stocks.

The approach can help limit your overall portfolio risk as you grow older and are more likely to need the money. There are even target-date funds, which automatically adjust their asset allocation to align with the investor's target retirement year.

However, even if you think purchasing bonds makes sense, beware that the pros and cons can vary depending on which bonds you buy and how you invest.

For example, the bonds offering the highest yield might have poor credit ratings and be risky investments. Or, you might think bonds that offer tax-free earnings will always be best, but you'll need to calculate the savings based on your effective tax rate and compare that to what you can earn from similar bonds that don't offer tax benefits.

Also, consider whether buying individual bonds or purchasing a bond mutual fund or ETF makes more sense. Buying shares in a fund can be easier, but funds may have additional pros and cons.

Match Your Investments With Your Goals

Bonds can be an important part of your portfolio, and may be especially appealing when interest rates are high and you can earn relatively good returns. But every type of investment has benefits and risks, and bonds are no different.

Being a successful investor partially comes down to understanding the pros and cons of each option, and finding investments that align with your risk tolerance and goals. If you're unsure of where to start or want a helping hand, consider contacting a financial planner for assistance.