Why invest in bonds?

Deciding to save and invest is the first step towards secure financial future. We can invest our money at many places but there are few options with low risks which might be stocks or bonds and among both investing in bond is better as they add safety and stability to your investment plan. Bonds are fixed-income investments, meaning that the amount of income you'll receive back on your investment is fixed in advance.

As every financial expert advises, the key to sound investing is diversifying – in other words, splitting your money up into different kinds of investments to reduce risk. The three main places to “park” your money are stocks, bonds, and cash/or savings.

Bonds can be a dependable source of steady, fixed income available for you to spend or reinvest.

The Benefits of Bonds

Financial Security
Who doesn't like the sound of “financial security”? There's a reason that a bond is called a “fixed-income” security – not only are you highly likely to get back your principal but you can also count on receiving interest on your investment.

Portfolio Balance & Diversification
Bonds can be great financial “buffers.” When the stock market is on a roller-coaster ride, bonds can help steady your pulse because they're a very safe financial tool to help balance the risk in your overall portfolio.

Tax breaks
One of the not so well known facts about bonds is that they're very often free from many taxes. For example, most bonds issued by state or local governments (also known as “municipalities” or “munis”) are exempt from federal income taxes. All bonds issued by the U.S. Government (also known as “Treasurys”) are exempt from state and local income taxes. Some municipal bonds (“munis”) are free from all three – city, state and federal taxes – a condition known as being “triple tax free.”

Weighing the Risks
Probably the first thing you've heard about investing is that it's never risk-free. True enough. And although highly-rated bonds are considered one of the safest ways to invest your money, you should still take the risks into account before making any decisions.

Bankruptcy
Bond issuers are not some mysterious “Wizard of Oz”-like entities. They're companies and units of government. And, sad to say, companies and sometimes even local governments can go bankrupt and default on their loans. Bonds with high credit ratings very seldom default and U.S. Treasury securities are considered essentially risk-free. But it's a fact to consider. Even bonds (except Treasurys) aren't risk free.

Your bond is “called”
Some bonds can be paid back early – what's known as your bond being “called.” If you own a callable bond and it is called you will still be paid back your initial investment and any interest you've earned so far, but you will not receive the future interest you would have otherwise gained. From our example, let's say your 9% bond was called after 8 years. You would be repaid your initial $1,000 investment (the principal), plus the $720 you had accumulated in interest. However, you would not receive the additional interest you were expecting when you made your initial investment for 10 years. Most important, if the company decided to call the bond, chances are that interest rates are now lower and you won't be able to find a similarly rated bond paying as high as the original 9% interest you were receiving.

Rising inflation
If inflation rises, the interest you make on your initial investment will look low compared to bonds currently being issued. And with your money locked in a bond, you could lose some principal if you sell it in order to move it into another investment that could give you a higher rate of return.

Selling your bond before maturity
If you decide you need your money back earlier than the date that your bond matures, You're taking “a chance” that you may get more, or less, than you paid. This depends mostly on the interest rates at which new bonds are being issued. That's why individuals who invest in bonds typically plan to hold them till they mature. And that's why it's important to determine when you'll want, or need, to reach your financial goal in order to purchase a bond that matures at that same time.
Now that you understand the benefits and risks, you should better understand the importance of bonds as part of your overall portfolio – they add some safety and stability to your investment plan. Next let's look at your bond buying options.
Source: Tomorrow's money