Pros and cons of investing in bonds

Traditionally, bonds are a popular tool for building a balanced and diversified portfolio invested in a mix of assets. While bonds can be a steady source of fixed returns, bond prices took a nosedive in 2022 as the Federal reserve hiked interest rates aggressively, so it’s also important to consider their risks.

Bonds are often issued by governments or corporations to borrow money. The likelihood that the issuer will repay an investor depends on the issuer’s ability to pay. Many bond issuers have a strong track record of making debt payments. As a result, investors often seek bonds to provide a predictable stream of income with relatively lower risk.

While the yield or return on bonds provides a degree of certainty, it can also be a double-edged sword. On a bond offering a fixed interest rate, bondholders may be stuck with an unfavorable rate when interest rates rise, reducing their overall returns. Bond investors also need to be mindful of default risks in the event the issuer is unable to make payments. In this section, we’ll take a look at the pros and cons of investing in bonds.

The pros of bonds include a range of benefits for investors, such as:

• Lower risk. Bonds backed by issuers that can repay their debts are lower-risk investments than many other assets. For example, U.S. government bonds are backed by the full faith and credit of the U.S. government and typically pay interest and principal payments on schedule. U.S. government bonds are considered nearly risk-free. Even if a bond issuer cannot repay and decides to default, bondholders are usually paid back first before stockholders.

• Portfolio diversification. Bonds offer a different investment profile because of their lower risk and income streams. Most investors use bonds to balance their portfolios against risky investments like stocks. The numerous types of bonds available also offer different risk and return profiles.

• Predictable income stream. Interest from bonds can be a steady source of income for bond investors. Coupon rates may be fixed or variable (meaning they are subject to change). The terms of the bond like the coupon rate and time to expiration — also known as maturity — are agreed upon in advance.

• Tax exemption. Typically, any income from investments is taxable unless it’s generated in a tax-deferred account. However, certain bonds can be tax-free — such as municipal bonds at the federal level.

• Attractive interest rates compared to a bank. Bond interest rates are usually higher than rates received in savings and checking accounts.

Not many assets are risk-free, so let’s consider some of the cons of bonds.

• Interest rate sensitivity. The value of bonds goes down as interest rates go up. In a rising interest rate environment, your bond holdings may drop in value. This is really only an issue if you decide to sell your bond before maturity. Declining bond prices do not affect the predetermined interest rate and will not affect your initial investment if you hold your bond to maturity.

• Exposed to inflation. Inflation, which is the rising cost of goods, reduces the value of all assets — including bonds. Bonds with fixed interest rates are especially susceptible to a decline in value, while bonds with floating interest rates fare better.

• Lower return on investment. In the long run, the return on bonds is usually less than the return on stock investments. Asset classes that have a riskier profile, like venture capital — which invests in early-stage companies — tend to have higher returns than bonds.

• Risk of default. Bonds are not always a guaranteed source of returns. The bonds that pay a higher coupon rate usually have a higher risk of default.

• Fixed repayment terms. Bonds are contractual agreements with terms decided upfront. For example, trying to sell certain government bonds like I Bonds before expiration may incur penalties.

• Liquidity concerns. Certain bonds may not enjoy a liquid market to trade in after purchase. If you can’t sell a bond, you may have to hold it to maturity.

• Minimum investment requirement. Many bonds require a minimum investment threshold. Without enough capital, you may not be able to buy certain bonds.

Bonds investing can get tricky because of the many types of bonds available. Let's take a look at some of the most frequently traded bonds.

Series I bonds are U.S. government bonds designed to protect investors from inflation. The bondholder receives a fixed coupon rate and a floating rate that adjusts based on inflation. The rate for savings bonds issued November 1, 2022 to April 30, 2023 is 6.89%.

Pros of I bonds:

• Reliable inflation hedge from interest rate adjustments

• Exempt from state and local taxes

• Backed by the U.S. government

Cons of I bonds:

• Initial rate only guaranteed for first six months

• One-year lockup of funds

• Interest penalty for early withdrawal after 12 months and before five years

• Subject to annual purchase limits

EE bonds are U.S. savings bonds that offer a fixed coupon rate over 30 years, a guarantee that the bond’s value will double after 20 years, and the option to cash in the bond after 12 months. The rate for these savings bonds issued between November 1, 2022 to April 30, 2023 is 2.10%.

Pros of EE bonds:

• Guaranteed by the U.S. government

• Not taxed at the state or local level

• Defer paying federal income tax until you cash in the bonds or after maturity

• Transferable to dependents like kids and grandkids

Cons of EE bonds:

• Low yields

• Not adjusted for inflation

• Usually underperform against riskier assets

U.S. Treasury bonds are government-backed bonds that pay a fixed interest rate every six months until they mature. Treasury bonds mature in 20-year and 30-year terms, but you can sell them in bond markets before they expire.

Pros of Treasury bonds:

• Guaranteed by the U.S. government

• A liquid market that makes them easy to trade

• Available for direct purchase from the government without a broker

Cons of Treasury bonds:

• Low yields compared to corporate bonds

• Interest rate risk from rising rates

• Political risk can impact the government’s ability to repay debt

• No inflation adjustment

U.S. Treasury notes are debt securities issued by the U.S. government at fixed interest rates for periods ranging from two, three, five, seven, to ten years. Interest payments are paid twice a year — every six months. 10 year Treasury Notes are a common benchmark for interest rates on mortgages and corporate debt. The rate for 10 year Treasurys issued on 2/15/23 is 3.5%.

Pros of Treasury notes:

• Shorter maturities mean shorter times to repayment

• Fully backed by the U.S. government

• Tax-exempt from state and local taxes

Cons of Treasury notes:

• Relatively low yield

• Interest rate risk from rising rates

• Inflation risk that could decrease the value

Treasury Inflation-Protected Securities (TIPS) are government-issued bonds that protect against inflation. Instead of an interest rate adjustment, the principal of a TIPS adjusts during its term. TIPS are issued with a term of 5, 10, or 30 years. At expiration, you receive either an increased principal amount or your original amount. Interest is paid every six months until maturity. The rate for 10 year TIPS issued on 1/19/23 is 1.125%.

Pros of TIPS:

• Inflation hedge based on adjusting principal

• Fully backed by the U.S. government

• Fixed interest rate is never less than 0.125%

• Not subject to state or local taxes

Cons of TIPS:

• Lower yields

• Principal adjustment based on the Consumer Price Index (CPI) which may or may not reflect inflation rate you experience

Corporate bonds are a type of company financing where bondholders loan principal to a corporation in exchange for interest and principal repayment at maturity. Maturities on corporate bonds vary between:

• Short-term: less than three years

• Medium-term: four to ten years

• Long-term: more than ten years

Bonds with longer terms tend to have higher interest rates, but they may also come with more risks.

Pros of corporate bonds:

• Additional diversification from exposure to different sectors

• Yields tend to be higher than government bonds

• Liquidity available for buying and selling

Cons of corporate bonds:

• Default risk is typically higher than for governments

• Company-specific risk impacts repayment

Municipal bonds are bonds issued by government entities like local, county, and state governments. These are often used to fund public amenities like highway construction, libraries, public parks, or schools. Municipal bonds — also known as muni bonds — come with a range of maturities, from two to thirty years.

Pros of muni bonds:

• Federal tax exemption on interest

• Some states and municipalities also do not tax interest

• Minimal default risk, especially compared to corporate bonds

• Low volatility in price

Cons of muni bonds:

• May underperform other assets like stocks

• Not an inflation hedge

• Despite low risk, defaults have happened before such as in the city of Detroit in 2013

Bonds are a diverse asset class that offer a variety of investment vehicles including convertible bonds and foreign debt. If you’re interested in learning about other types of bonds and investing in bonds, consider working with a financial advisor to determine the most suitable types for you.

Bonds are debt instruments used by issuers to borrow money and investors to obtain income. These popular securities offer predictability and reliability through an agreed interest rate. The rates bondholders earn are generally higher than those widely available in savings or checking accounts. A predictable income stream can be especially appealing to conservative investors. However, holding bonds is subject to the risk of default by the issuer. Bonds can also decline in value when interest rates or inflation is high.