Bonds provide a fairly predictable stream of income. They are called fixed-income securities because the amount of money you receive and the dates on which you receive your payments are specified in advance. Fixed-income securities typically have a lower risk factor than stocks. Of course, any investment involves risk.
Risks and Rewards of Bond Investing
Bond owners receive income even if the issuer isn't performing well. If you purchase corporate bonds, your rate of return remains the same whether the firm meets with success or difficulty. You are not as exposed to fluctuations in the issuer's performance.
Not only can bonds generate a regular income stream for investors, sometimes that income stream may be tax-free, making them attractive if you have a high tax burden. Tax ramifications will depend on the type of bond, the issuer, and your resident state. Consult your tax advisor to discuss bonds that may reduce your tax exposure.
While bonds are known as safe investments, you should be aware of potential risks, including:
- Interest rate risk: Also known as market risk, this refers to changes in bond prices due to interest rate changes. Bond prices and interest rates behave as if they are on opposite ends of a see-saw: as interest rates increase, the price of existing bonds decreases.
- Credit risk: As a bond investor, your objective is to receive regular coupon payments and the face value of your bond at maturity. Credit risk occurs when the bond issuer's financial troubles negatively impact your payments.
- Inflation risk: If the Federal Reserve raises interest rates to combat inflation, your bond investments may lose value.
- Reinvestment risk: For long-term investors, declining interest rates may require you to reinvest your interest income and principal at the new, lower prevailing rates.
- Selection risk: This is the risk that you choose a security that underperforms the broader market. You can reduce selection risk with smart research.
- Timing risk: The risk that an investment performs poorly after you buy it or better after you sell.
- Additional expenses: Don't overlook the costs associated with investing like commissions, markups, markdowns, or other fees. If those costs are excessive, they can detract significantly from your net return.
There's always the risk that a bond issuer will become insolvent and default on the bond. In that case, you'd have to engage in some legal wrangling to receive even a small portion of the money that's owed to you for the coupon and face value of the bonds. Don't be tempted by the higher interest that comes with high-risk junk bonds.