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Trading Bonds: Pros and Cons

The two biggest type of investments made by investors are either into bonds or stocks. Whilst everyone talks about stocks, not many talk, or even know a lot about bonds. However, that doesn't mean to say that you should ignore investing in to bonds. On the contrary the bond market represents many advantages over stocks. Today, we focus not only on the advantages of investing in bonds but also the disadvantages so you can decide if and when you want them in your portfolio.

Advantages of investing in bonds

The first main advantage of investing in bonds is why many investors and fund managers do so - they are low risk and act as a safe haven for your capital.

When investing into bonds you are essentially investing into debt, as you are lending money to a company and they will pay you an interest rate for doing so. That means if the company went bankrupt, as a debt holder, you'll be first in line to get your capital back, unlike shareholders who would be last.

Another advantage is the fact you can diversify your portfolio and invest into government bonds also.

In terms of safety of your capital, bonds issued by the US government, known as Treasury bonds, are actually considered 'risk free'. What better product to have in your portfolio than a risk free investment from the United States government?

Of course, whilst bonds suit the 'slow and steady' crowd they are also used cleverly by investors who look at the economic cycle.

That's because at certain times in the economy, bonds can outperform the returns on the stock market, especially during financial crashes like the last recession of 2008.

So, we know bonds are great because they are low risk, and in some cases offer zero risk, they help to diversify one's portfolio and they help to balance out negative return in the stock market.

But are there any disadvantages? There's a few which we study below.

Disadvantages of investing in bonds

One of the biggest disadvantages of bonds is the effect interest rates have on them.

Let's say interest rates start to fall, most investors would want to lock in the highest rates possible so they can still grow their capital.

Therefore, investors would tend to flock to bonds that pay the highest rate of return, or interest rate in the case of bonds. That generally leads to a huge surge in demand which increases the cost price of bonds.

Another disadvantage of investing in bonds is the inflation risk they carry. Let's say inflation was on the rise which causes the cost of living to rise 3%.

If an investor bought a bond paying a 1.5% interest rate then they would actually be losing money on their 1.5% as inflation erodes its purchasing power. In fact, they would have a negative return of -1.5% (1.5% - 3%) which is clearly not an ideal scenario.

Another risk when investing into corporate bonds is something called 'credit risk'.

When you a buy a corporate bond you are actually buying a 'certificate of debt' as you are lending them money in return for a fixed interest rate. However, corporate bonds aren't guaranteed by the full faith and credit of the government and actually only depend on the company's own ability to repay that debt back.

As you can see, there are pros and cons to investing in bonds.

However, most of the advantages and disadvantages depend on what is happening in the economy and where it is within the economic cycle. Are interest rates falling or rising? Is inflation on the rise or is it decreasing?

These are important questions to answer as that will depend on whether or not purchasing bonds will have a positive or negative impact on your portfolio.

However, one thing is for sure, the savvy investor can turn the disadvantages of bonds into having a positive effect on their portfolio by analysing the economic situation.
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