The fluctuating stock market has made other investment vehicles, such as bonds, more attractive—and for good reason. Although stocks can boast an average annual growth of around 11 percent as compared to less than 6 percent for bonds, bonds provide real benefits to a wide range of investors. According to the California Society of CPAs (www.calcpa.org), these include safety, predictability, income, diversification, and tax savings.
REASON #1: Safety
For many investors, bonds represent capital preservation. The degree of safety varies based on the bond's credit strength, but investors generally can be reasonably certain that their original principal will be returned in full if they hold a bond to maturity. That's not to say that bonds are without risks. Bondholders face credit and market risk.
Credit risk refers to the possibility that the bond issuer will default. Market risk depends on whether interest rates will rise, making those bonds issued when rates were lower worth less. You can minimize credit risk by limiting your purchases to Treasury securities and to bonds with the highest ratings. It also helps to diversify your bond holding across many industries or governments. Owning bonds that have staggered durations, a practice known as laddering, can help to reduce market risk as well.
REASON #2: Predictability
Bonds offer a conservative way to fund future expenses. If you know that you will need money at a set time—to pay for a child's education, for example—you can buy bonds that come due then and give yourself the peace of mind of knowing the money will be there when you need it.
REASON #3: Income
Conservative investors often use bonds to provide steady income. When it issues a bond, a company guarantees to pay back your principal (the face value) plus interest at a preset, if modest, rate of return. The interest they pay, known as the coupon, is typically a fixed amount. For example, a $10,000 bond issued with a 7 percent coupon generates interest payments of about $700 each year, thus the term "fixed-income investment." Generally, bonds pay higher income than short-term investments, such as money market funds, CDs, and savings accounts.
Since different types of bonds pay interest at different times, with careful planning and purchasing, an investor can assemble a bond portfolio that offers a constant income stream.
REASON #4: Diversification
It is a well-accepted fact that an investment portfolio's success depends greatly on its asset allocation, that is, the percentage of funds invested in stocks, bonds, and cash equivalents. By spreading across a variety of investments, diversified portfolios generally offer more reliable and stable returns over time.
Although stocks generally perform higher over the long term, stocks and bonds do well at different moments in the economic cycle. Bond prices tend to rise and fall at different times and rates of speed from stocks, offsetting the volatility of the market. It's been said that adding bonds to a stock portfolio lowers its return—but it lowers its volatility more.
REASON #5: Tax Savings
If sheltering income from taxes concerns you, consider tax-free municipal bonds. States, cities, counties, and towns all issue bonds to finance a wide variety of public projects. In order to encourage investors to lend money to pay for these projects, interest on municipal bonds, or "munis" as they are commonly called, is exempt from federal income tax. If you buy bonds issued by your own state, they are free of state income taxes as well. Because of this advantage, munis usually pay a lower interest rate than corporate bonds, making them appeal most to investors in high tax brackets who stand to benefit the most from the bonds' tax exempt status.
Know What You're Getting Into
Investing in bonds can be more complicated than you might think. To learn more about how bonds can enhance your investment strategy, consult with your CPA.