Reducing Risk Through Bonds
Investors are worried as the stock markets across the globe falter. This is not surprising, considering how many have had their hands burnt during the recent financial crisis. Therefore it is essential to consider alternatives to the stock market where investors can feel safe about their money and also make some return on investment. Bonds are one of least risky investment vehicles that every investor should make use of. These are debt instruments and not equity, which means the investor will get a fixed rate of return on the investment. This sounds quite similar to the way bank deposits work, by paying a fixed rate of interest on the principal deposited but there are some notable differences between a bank deposit and a bond. A bank deposit interest rate is a value below its loan value, which means it is not feasible to pay back a cash loan using the interest from a bank deposit. On the other hand, a bond typically has a higher rate of interest, which means a higher return on investment.
One aspect of the bond market that many investors initially overlook is the period of investment. Unlike a bank deposit, bonds cannot really be dissolved at any arbitrary point of time when one needs money. These are held for a fixed period of time, say 5 years or 10 years. One will only get the full money – interest with the principal amount, after this period of time. The interest is usually calculated compounded annually. Thus, before an investment is considered in the bond market, every investor should make sure to have his investment goals before him, so that he can determine the right period of investment for a given bond. If one needs money in the immediate future, bonds are not the best investment vehicle. On the other hand, if one is looking at long term savings, then bonds can give excellent returns.
One should also remember that the bond is a debt instrument, which means a company is in essence borrowing from the investor at this rate of interest. If the company collapses for any reason, one’s investment is in jeopardy. Therefore one should preferably invest in good quality bonds. Bonds are rated by a number of established institutions, depending on the country of the parent company. In addition, one can take some amount of risk to invest in companies that do not have a perfect score with the rating companies. This is a good strategy because the risk carries a higher return on investment – bonds of such companies typically carry a much higher rate of interest and thus more profitable. One can take a small cash loan for investing in equity but it is not advisable to do so in the case of bonds because the rate of interest earned usually doesn’t cover the loan costs.
Filed under: Financial Advice