Bonds are an investment option available to any investor. When you buy a bond, you essentially give a small loan to a company or agency. The agency pays you back when the bond reaches its date of maturity, usually with interest. These investments are a basic part of an investment portfolio. Using bonds as an investment has some disadvantages, however. Investors must be aware of the risks that result from bond use in order to minimize the possibility of financial loss.
Depending on the type of bond you purchase, it can take up to 30 years for the bond to reach maturity. Even short-term bonds may not mature for several years. This means that when you buy a bond as an investment, you tie up your money for a significant period of time. You may cash in or sell a bond prior to the maturity date if you need immediate access to your funds, but usually this means taking a loss because of the penalties or fees associated with sale or early redemption.
Penalties and Fees
If you keep your bond until it matures, you usually are able to collect the face value of the bond, plus the interest, if any. If you need to cash the bond early, you will have to pay whatever early redemption penalty the bond has. This varies by bond type, but you usually have to forfeit at least the interest accrued in the last three months. Bond dealers, brokers and other financial professionals who are qualified to sell and buy bonds for investors have expenses and also want to make a profit. Thus, they mark up the price of a bond when an investor buys and mark it down when the customer sells it, as explained by InvestinginBonds.com. This means you may not get back what you paid for the bond.
Compared to other investments such as stocks, most financial advisers consider bonds to be a low-risk option. However, agencies and companies that issue bonds can and do go bankrupt occasionally. In fact, bonds by definition are debt securities, meaning that the issuer owes the buyer for the money loaned via the bond purchase. This can be a sign that the agency or company is not financially solid. If the agency or company that issued your bonds gets into serious money trouble from which it cannot recover, your bonds may lose value or, in the worst-case scenario, become worthless. Additionally, some bonds are callable. This means that the company or agency that issued it can call in the bond for early repayment and thereby get rid of its outstanding debt. With this type of bond, you do not know if you will have the bond until the date of the maturity, which makes financial planning somewhat more difficult. If the bond gets called, you may have to settle for a rate of interest that is lower than what it might be at the maturity date. You also may have to reinvest the money in an option with a lower interest rate.
The general rule of thumb with any investment is that higher risk can provide higher return. This is because agencies and companies that provide higher-risk investments are willing to pay investors more to take a chance. This is not unlike credit card companies earning more from the higher interest rates charged to high-risk borrowers. Bonds have a risk level that isn't as high as other forms of investment because many companies and agencies find a way to guarantee the bonds they issue. They therefore usually have lower interest rates and a lower profit potential. The interest rate paid on bonds usually does not keep pace with inflation.
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