In times of economic uncertainty, investors typically shift their investments from higher risk financial instruments like stocks, to lower risk fixed-income assets such as bonds.
A bond is basically a debt security that is similar to an IOU. When you buy a bond, you are lending to an issuer, which could be a government, municipality, or corporation.
In exchange, the issuer promises to pay a specified rate at set intervals (typically twice a year) during the lifespan of the bond and to repay the principal. This principal is also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time.
Bonds provide a means for companies, governments and municipalities to raise large amounts of money for various things. They may include to:
In general, bonds pay interest semi-annually or annually providing a stable income stream over a set period. Many people invest in bonds for interest income (also referred to as ‘yields’) and also to preserve their capital investment (which is why it is often referred to as fixed income instruments).
They might not provide the returns that stocks may generate due to their lower risk and fixed income characteristics, but are an important component of a strategically-diversified portfolio at any stage of an investor’s life.
For instance, having a diversified portfolio that includes bonds over the long-term can often provide comparable returns with less risk than a portfolio devoted to only one type of investment.
To establish proper diversification, an investment portfolio should consist of multiple asset classes, including high, medium and low risk investment instruments. Bonds can provide income investment stability to help buffer against the volatility of the stock market.
Here are some benefits that bond investments can provide:
The first thing you need to do is to consider your financial goals. What is your investment objective? Is it to have enough money to pay for the down payment of your first home? Or to live comfortably in retirement? Perhaps both?
It is important to lay out your goals precisely so you can map out your investment horizon, as well as your risk-taking abilities.
Shorter-term bonds have maturities of one to five years, and usually with lower yields. Meanwhile, long-term bonds can take from 10 to 30 years to mature, but typically comes with higher yields.
For investors with a longer investment horizon, more risk can be taken, since the market has a long time to recover in the event of a pullback.
What to look out for when investing in bonds
While many have the perception that bonds are a “safe” investment, it is still driven by the same risk/return trade-offs as the stock market as a company (or even a government) and can be subject to sudden changes impacting their ability to pay off a bond. An investor will need to master these market dynamics to become a competent bond investor.
Finally, it goes without saying that before investing, an investor should always consider the funds’ investment objectives, risks, charges and expenses.
Graphics by Fiona Ho.