In the current economy many can see how volatile our equity markets are. As a result, investors look for new places to store their wealth so they can weather the storm. There are many good reasons to invest in bonds as an alternative. Bonds are less risky than equities, but they are known to have a lower return on investment. Here are five reasons why bonds are good investments:
In finance, the bond investment vehicle is actually a debt security and it makes the holder of that bond a creditor. An equity shareholder or stockholder is seen as proportionate owner of the company. In an ideal economy, purchasing stock would be a wiser choice because the returns are higher. However, in an unstable economy where major banks fail and go out of business often, investing in bonds could be your ace in the hole.
During the banking/mortgage crisis, a company would close up shop on a daily basis. When a company files for Chapter 11, otherwise known as bankruptcy, they must follow certain procedures to attempt to save their company or liquidate its remaining assets. According to the corporate dissolution process, a creditor has a higher priority over stockholders. Therefore, when a company is liquidated, the creditors get paid first and the equity shareholders split whatever is left.
Your typical bond investment is bought at the discount price and at full maturity the issuer gives you par value, which is more than what you paid. Between the dates of issuance and maturity, the bond can pay interest based on the coupon rate. However, not all bonds pay interest to their holders. The set time-frame and payout of the investment, makes it more stability than stocks. Historically, the bond market doesn’t fluctuate as much as the stock market. Bond prices are usually affected by either interest rates or credit ratings. Therefore, because the rates are controlled by the government and the ratings are split between two major institutions, volatility in the bond market is unlikely.
Risk Free Investment
Not all securities are created equal. Depending on the rating agency (Moody’s or S&P), bonds can be given “junk” (high risk) or “AAA” (virtually no risk) status, but they still have inherent risk. However, there is one type of bond that is considered “risk free.” These are called “treasury bonds” and they’re backed by the “full faith and credit” of the U.S. government. Although these bonds pay the lowest interest rate, some people believe that the returns are worth sacrificing for the security of the investment.
The U.S. government may issues bonds, but what about states and cities? Actually, bonds issued by a state, U.S. Territory, city, local government, or their agencies are considered “municipal bonds.” The interests from these municipal bonds have special properties. Barring a few exceptions, the majority are exempt from federal income tax as well as the income tax of the state in which it was issued. This is a great option for those who want a safe investment without raising their taxable income level.
Interest bearing bonds are often referred to as “fixed-income securities” because of its consistent payout to the bond holder. Investors take advantage of the low risk, consistent payouts, and tax exemptions to build themselves bond portfolios that produce consistent income over the year. Some investors also refer to this strategy as “bond laddering.”
To begin, the investor needs is to know how much income is required over a specified period of time. Bond ladders for $1,000/month would be a little different than $10,000/year. This is required to synchronize payout dates, but more importantly give you can idea of total investment. At an average return of 1%, you’re looking at about a million dollars’ worth of bonds to make your yearly mark. This may seem somewhat complicated, but this strategy is usually taken by retirees and/or trusts that want safe income producing investments. If you fall into these categories, do more research on investment strategies by searching for “bond laddering” and “fixed income investment portfolios.”