There are several advantages to bonds. They are typically less risky than investing in stocks or equity. They can also provide a good, stable income through the interest payments. Many experts suggest investing in bonds if you are looking for steady interest income but have less tolerance for risk than typically associated with investments made in the stock market.
Examples of scenarios where investors may choose to invest in bonds:
- A young investor that is aggressive in their investments may have the large majority of their investment funds in the stock market (equity investments) because they have a long investment time line, and they can bear the risks associated with these types of investments (and the likely rewards due to average returns being around 10%). However, this type of investor may want to put a small amount of their investment into bonds (say 10%) to diversify their portfolio and mitigate risks.
- As investors get older and are more dependent on their savings accounts for their future wellbeing, they may put a larger amount of their investment portfolio into bonds (perhaps 50% or higher).
- An investor that has a large sum of money that they want to live off of and who does not expect to make significant additional income from other sources may invest in stable bonds to provide a steady income through the bond interest.
However, there are still risks associated with bonds. These risks mainly arise from the fact that the entity that issued the bond (whom you make the loan to) may not be able to pay the interest rates due to you or may not be able to pay back the nominal value. This is typically referred to as the bond "going bust." This risk varies depending on the type of bond you invest in. Government bonds, or gilts, tend to be the most stable and many are virtually guaranteed.
Corporate bond risk is associated with the stability of the company. If you believe the company is a strong, stable company with very little risk of incurring financial ruin, then the risk associated with the bond is typically less. If the corporate bond is with a less stable or less proven company, then the risk is typically higher. Interest rates tend to follow the credit rating of the companies that issue the bonds. In general, with higher risk comes higher interest rates. Ultimately, you want to find a good stable bond with as high an interest rate as possible.
There are also bond funds that invest in multiple bonds. The benefit of these is that they spread the risk over several bonds and therefore diversify your investment and mitigate risk.