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Advantages & Disadvantages of Buying Bonds

Original post by Wanda Thibodeaux of Demand Media

Bonds are fairly low-risk, but there is still the possibility of the issuer defaulting.

Companies, governments and government agencies issue bonds to raise money for necessary projects. When the bond matures, the issuer pays you back in full, and typically pays regular interest payments until the bond reaches maturity. These investments have advantages and disadvantages. Skilled investors understand the risks and benefits of bonds and are able to address these factors in such a way that they maximize profit.

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Risk

Bonds often are backed. This just means that the issuer has a way of guaranteeing it will pay you what it owes. For instance, the U.S. Treasury backs government savings bonds. The fact bonds are backed translates into relatively low risk compared to other forms of investment. On the other hand, bonds are not completely risk-free. If the issuer goes bankrupt, it may default on its bonds. However, in bankruptcy, bondholders are paid back first, before shareholders. An advantage of bonds is that various companies provide ratings for the companies that issue them. The best rating is AAA, while a D bond is in default. These ratings are not a guarantee of what will happen in the future, but they offer a guide for assessing bond risk and whether you'll get your money back.

Return

Because bonds are a relatively safe investment, they provide a relatively low return. Bonds do not produce returns that keep pace with other investments such as stocks. If you know you'll need a sizable amount of money later on, this makes bonds a poor investment option. Bonds also have trouble keeping up with inflation. However, bonds are fairly predictable. You know when the company will pay you and what the interest rate is. Subsequently, it is easy to plan financially with bonds based on the returns you expect.

Access

Bonds tie up your money for an extended period of time. Bonds can be considered short-term investments, but depending on the bond, the tie-up period may be as long as 30 years. You usually can cash in a bond before it matures, but not without a penalty that reduces the overall value of the bond. This makes it somewhat difficult to shift your money from place to place and keep it working for you based on your needs.

Taxes

Some bonds are exempt from certain taxes. For example, the interest on U.S. savings bonds is exempt from state income tax. This increases the value of the bonds. However, you sometimes have to meet certain conditions to qualify for the tax advantages. For instance, you can't exempt your interest from federal income tax unless your income is below a certain level, according to Retirement Planning Services.

Registration

The majority of bonds are registered securities. This means the issuer has a record of the person or agency that purchased the bonds. If your bonds are ever lost or stolen, the registration is useful in tracking the bond and proving your entitlement. At the same time, registration means you may not be able to simply sign over the bond, which makes transferring ownership more complicated. With U.S. savings bonds, for example, you must change the registration with the Treasury and have the bond reissued to show the change in ownership.

Portfolio Diversification

Financial experts recommend putting your funds in many different investments to minimize risk. This way, if one investment fails, you don't lose everything. By purchasing some bonds, you spread your money out over more types of investments and therefore have a stronger portfolio overall. The stable rate of return from bonds in your portfolio also can cushion volatility in the stock market.


                   

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About the Author

Wanda Thibodeaux is a freelance writer and editor based in Eagan, Minn. She has been published in both print and Web publications and has written on everything from fly fishing to parenting. She currently works through her business website, Takingdictation.com, which functions globally and welcomes new clients.

Photo Credits

  • Comstock/Comstock/Getty Images


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