Home » Business & Finance » Fixed Income & Bonds » Why Bonds?

Why Bonds?

© Naeem Akhtar

Who needs bonds? The question is frequently asked with disdain. But anyone who wants a balanced investment portfolio would do well to hold at least a small number of high-quality bonds. In fact, with inflation low, this is the best time in years to consider this underappreciated asset class. True, most bonds aren't exciting. They're certainly not racy like stocks. But they're not meant to be. Says Long Island, NY, financial planner Ron Roge, "Bonds were specifically designed to be a low-risk, low-return investment."While bonds are predictable and usually low-risk, they're not risk-free. When you buy one, you're the bank. Typically, your top concern is credit risk - the chance you won't get repaid. So you first have to consider who's borrowing and when you can expect repayment.

The interest rate you're offered to part with your cash depends on these two factors. The less credit-worthy pay higher interest, as do borrowers who want your money for many years. For example, the bond of a company in a shaky business will pay, or yield, more than a bond from an established corporation, since the more-solid company is less likely to renege, or default, on its obligation. A five-year bond typically yields more than a one-year bond - your compensation for being locked in and unable to reinvest the principal if interest rates rise.

Besides credit risk, bonds carry interest-rate risk. Suppose you need to sell one before its due date, or maturity, and interest rates are higher now than they were when you bought it. In that case, the bond's value will be lower, since bond prices move opposite to interest rates. Say you pay $10,000 for a 30-year US government bond that pays 6 percent annual interest, and then the interest rate on government bonds jumps to 7 percent. No one will give you $10,000 for 6 percent interest when they can get a similar bond with greater yield. If the rate drops to 5 percent, on the other hand, that 6 percent bond will be worth more than the $10,000 you paid. Hold the bond until maturity, and interest-rate fluctuations won't affect its redemption value - you'll get back exactly what you invested. But that doesn't mean you'll have avoided interest-rate risk. If rates rise after you buy a 6 percent bond, you'll lose potential income for all the time you're stuck earning 6 percent while new bonds pay more.

Interest payments usually are made every six months over the bond's life. The interest is taxed as ordinary income, as if you'd earned the money on the job. How much income you'll get is predetermined, or fixed, at purchase, which is why bonds are called fixed-income securities. A $50,000 bond that pays 5 percent annual interest for 10 years will add $2,500 to your income each year over the next decade, no matter what. At the end of that time, you'll get the $50,000 back. That's why bonds appeal to retirees, the risk-averse, and those who'll need money at a specific time to make a major purchase or send a kid to college.

The copyright of the article Why Bonds? in Fixed Income & Bonds is owned by Naeem Akhtar. Permission to republish Why Bonds? in print or online must be granted by the author in writing.