Advantages and disadvantages of bonds

Written by kent ninomiya | 13/05/2017

There are pros and cons to buying bonds. Bonds can produce a steady stream of income, but they tend to be less aggressive than stocks. The result can be poorer overall performance over the long-term. There are also risks involved with investing in bonds. Fortunately, there are resources available to help you determine the advantages and disadvantages of bonds for you.

Income Advantage

An advantage of bonds is that they tend to be a more secure place to invest money than stocks. Bonds are debt securities. When you buy a bond you are lending money to someone who promises to pay you back with a set amount of interest by a specified date. Bonds can be issued by a government entity, a business or a private issuer. Bonds can be traded like other securities, so their purchase price can change. However, the fluctuation of the price tends to be less volatile than stocks.

Security Disadvantage

A disadvantage of bonds is that they are only as good as the borrower's ability to pay the loans back. If the issuers of the bonds cannot pay back what they agreed to, the bonds will default. It is also a disadvantage if bonds are repaid early in a bond mutual fund. The bond fund managers who were expecting continued income from those bonds may suddenly be forced to buy other bonds that don't pay as well. Longer maturity bonds can fall in value with fluctuating interest rates. This lowers the sale price of the bonds when it comes time to sell them.

Rating Advantage

An advantage of bonds is that they are subject to ratings systems. This allows investors to gauge how reliable a bond is expected to be. There are several companies that assign letter grades to bonds based on their credit worthiness. AAA is the highest rating. A bond rated AAA is considered very likely to be repaid on time and in full. There are also ratings of AA, A, BBB, BB, B, CCC, CC, C and D. Bonds rated with Cs are considered unreliable and referred to as "junk bonds." A bond rated D is in default. Treasury bonds backed by the United States government have no ratings. They are considered the safest bonds of all. Many bond mutual funds guarantee investors that they will only buy AA bonds or better.

Risk Disadvantage

A disadvantage to bonds is that you can not always trust the ratings systems. The most prominent example of this is the home mortgage crisis of 2008. For years preceding the crisis, bonds and bond mutual funds containing mortgage loan debt were highly rated and considered safe. At the time, they provided consistently good returns and rarely lost money. When it became evident that there would be wide scale mortgage defaults, agencies like the Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Loan Mortgage Corporation, known as Freddie Mac, were on the verge of collapse. In September 2008, the Federal Housing Finance Agency seized control of Fannie Mae and Freddie Mac to prevent the entire economy from collapsing under the weight of so much unpaid debt. The bonds containing the unpaid debt became virtually worthless.

Tax Exempt Bonds

Income produced by bonds are considered income and must be reported on your tax return. Taxes then must be paid on the bond proceeds. This can significantly cut into the profits from bonds, especially for higher income earners. Investors who pay high taxes can take advantage of tax exempt bonds. Many municipal bonds are free of state taxes. Some of are also exempt from federal taxes. This is an additional incentive to invest in bonds since lower taxes result in larger gains. The disadvantage of tax exempt bonds are that they tend to pay less than ordinary bonds. Sometimes this can completely negate the tax savings.

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