Have you ever felt the need for safer assets to park your funds to seek relief from market upheavals? If your answer is yes, don’t shy off. Every investor must invest in bonds at some point in their investing roadmap. The intent is to reduce their risk through diversification or capital preservation.
However, the bond market has both risks and rewards. If you understand the right way to invest in bonds, you can achieve your financial goals in the long run, from building your dream home to adding to your retirement corpus.
And, if you don’t adopt the right techniques, you can incur losses even if bonds are considered safer than equity investing. So, let us understand how you can invest in bonds for the long term.
In this article, we have covered the basics of bonds in detail, from what bonds are and their types to the proper techniques to invest in bonds that you should know.
What are Bonds?
In simple terms, Bonds are written acknowledgments of debt that the bond issuer promises to pay the bond buyer. When you invest in bonds, you lend money to someone who promises to pay you back with a pre-determined interest rate. When you sell a bond, you get your money back, plus or minus some profit or loss.
But who are these people that you are lending money to?
You can invest in bonds issued by governments or corporations that need capital for various reasons. For example, the government may need money to build roads, schools, or hospitals. A corporation may need money to expand its business, buy new equipment, or research new products.
You can invest in bonds for various purposes with varying maturity dates. The maturity date tells you when you will get your money back. The face value of a bond means how much money you will get back. The coupon rate tells the interest you will be paid yearly as a return on your investment.
Is it risky to invest in bonds?
Let’s answer this common question in every investor’s mind. Bonds also have different levels of risk and return depending on the credibility of the issuer of bonds. Some bonds are safer than others because they are more likely to pay you back.
When you invest in bonds that pay you lower interest rates, it is because they are less risky. Or the risk of default is low, like government or municipal bonds.
When you invest in bonds that pay you higher interest or look more rewarding, it is because they are riskier than others. Their probability of default or the likeliness of not paying you back could be higher.
Types of Bonds
Bonds are often called fixed-income securities because when you invest in bonds, you get a fixed amount of interest every year until its maturity. The maturity of these bonds ranges from one day to 30 years.
Upon maturity of bonds, you get back the principal amount you invested. The bond market has various investment options. Some of the common types of bonds are:
|Features||Treasury Bonds||Municipal Bonds||Corporate Bonds|
|Issuer||Issued by government||States, cities, or other local governments||Issued by Companies or Corporations|
|Purpose||To finance its budget deficit or public debt.||To finance their public projects or services||To raise funds for their business activities|
|Interest||Usually, they have moderate interest rates, depending on the credit rating and financial condition of the issuer.||Usually have higher interest rates, because they involve higher risk||Municipal bonds are generally less risky than corporate bonds but more risky than treasury bonds.|
|Default Risk||Municipal bonds are generally less risky than corporate bonds but more risky than treasury bonds.||Municipal bonds are generally less risky than corporate bonds, but more risky than treasury bonds.||More risky than treasury and Municipal bonds as they depend on the financial performance and creditworthiness of the issuer|
Some other types that you may find in the financial bonds market are-
Zero-coupon bonds are also known as discount or deep discount bonds and do not pay you interest during your lifetime. In the Bonds market, these are sold at a lower price than their face value and redeemed at their face value at maturity.
If you want to invest in bonds with a lump sum amount to meet a long-term and do not need regular income from your investment, these bonds are a good choice. Zero-coupon bonds usually have long maturity periods, ranging from 10 to 40 years.
Floating Rate Bonds
Floating rate bonds are also known as floaters or adjustable rate bonds. Floating bonds can be a sound option if you decide to invest in bonds to drive benefits from the changing market conditions. You can also avoid the risk of falling bond prices when interest rates rise. Floating-rate bonds usually have short maturity periods, ranging from a few months to 5 years.
Benefits of Investing in Bonds
- Fixed Return on Investment- When you invest in bonds, you are very clear about what returns you will get (i.e., Coupon Rate) and when you will get the principal back (Maturity date).
- Better Risk Management– It is well-established that bonds are less vulnerable to market volatility and less likely to default than stocks. When you invest in bonds, you can better manage your risk by choosing the kind of bonds you wish to invest in. If your risk appetite is low, pick bonds backed by reliable issuers or have high credit ratings.
- Tax Benefits– When you invest in bonds issued by local or state governments, you can benefit from tax advantages or special exemptions. Municipal bonds are also tax-exempt bonds because the interest income from these bonds is usually exempt from state and local taxes.
- Portfolio Diversification- When you invest in bonds, you can effortlessly diversify your portfolio because it allows you to distribute risk across multiple assets. Maintaining a healthy balance between bonds and equity can cushion investors against interest rate changes and market swings.
Drawbacks of Investing in Bonds
Lack of High Return Potential – When you invest in bonds, you miss out on higher returns as they generally have lower yields than stocks or other assets. Bonds also have limited upside potential because their prices are constrained by their face value.
Poor liquidity- Investing in bonds may face liquidity issues, as some may be harder to sell or buy than others.
How to Use Bonds in Long-Term Investing?
Bonds work best for investors who are averse to making losses and those who value their capital preservation above all. So, if your priority is to make a low-risk bet, invest in bonds, especially treasury or municipal bonds that pay on maturity.
To multiply your returns with low risk and compounding benefits, you can reinvest the interest income in alternative fixed-income investments like recurring deposits (RD), Fixed Deposits (FD), or PPF.
When you invest in bonds, you get a predictable cash flow that you can use to fund your future expenses or build your retirement corpus. Bonds can help you add to your wealth building safely.
When you invest in bonds, one thing is very clear in your mind. That is, you will hold this investment till maturity. These fixed-income instruments can exponentially grow your savings to meet your long-term responsibilities, like funding your child’s education.
You can inflation-proof your portfolio by investing in inflation-indexed bonds, which boost their payments when inflation occurs and decrease their payments when deflation happens.
Every investor is unique in terms of its needs and goals. Whether you should invest in bonds that offer fixed interest or take wilder routes like equity depends on a few factors- like how early you are starting, your financial ambitions, how much risk you can afford to take, and how long you can stay invested.
If you are planning wealth building over the long term going through a safe and secured way, including bonds in your portfolio can be a good choice. Investing in bonds helps you diversify your portfolio, build future savings, earn a steady income, and cope with interest rate fluctuations. If needed, you can also seek professional or expert assistance.
What are the risks when you invest in bonds for the long term?
You may have to face a few risks when you invest in bonds, like chances of lower returns, higher costs, lower liquidity, and higher sensitivity to interest rate changes. Therefore, always go for portfolio diversification and monitor the market conditions to reduce risks.
What types of bonds I should invest in for long-term investing?
The answer to this question entirely depends on your goals, risk tolerance, and time horizon. Generally, long-term bonds have higher yields but also higher risks. You can choose from different types of bonds, such as treasury, corporate, municipal, floating rate, or zero-coupon bonds.
How do I measure the performance of my bond investments?
When you invest in bonds, you can track the performance of your investments by using various metrics, such as yield-to-maturity, yield-to-call, current yield, total return, duration, convexity, and credit spread.
I’m Archana R. Chettiar, an experienced content creator with
an affinity for writing on personal finance and other financial content. I
love to write on equity investing, retirement, managing money, and more.