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Are fixed rate bonds a good investment?

Fixed rate bonds also known as fixed income securities are considered to be a good investment option for an investor’s portfolio. It is suitable for investors who intend to generate a guaranteed interest rate for a given term. On maturity, the bondholders receive the principal amount along with the interest payment. Investors with low-risk tolerance level and a good understanding of risk can invest in bonds to build a diversified portfolio.

A long term bond yields a higher interest rate in comparison to the short term bonds. Also, the lock-in period ranges from 1 year to 5 years. Usually, the fixed rate bond issuers provide investors with an option to receive interest either monthly or yearly. On maturity, investors can either withdraw their money or reinvest in the same bond. Most of the government bonds issued in India are fixed rate bonds. Some of the examples for fixed rate bonds are treasury bills, treasury bonds, certificate of deposits, etc.

What are the disadvantages of bonds?

The major disadvantage of investing in fixed rate bonds is interest rate risk and market volatility. Investors may lose out in generating attractive returns when the inflation rises. Also, bond prices are indirectly proportional to the interest rate. In other words, bond prices rise when rates fall, and bond prices fall when the rate rises. Furthermore, the price of the bond at the time of maturity might be less than the price at the time of issue. Also, in case the investors wish to withdraw the money prematurely they will have to pay penalties.

Another disadvantage of investing in fixed rate bonds is credit risk. Sometimes the issuers might default principal and interest repayment obligations if they face cash flow problems. Hence, the investor must check the credit rating of these bonds before investing in them. Also, the long term bonds are more likely to be associated with inflation risk as the rate keeps changing frequently.

What is the advantage of investing in bonds?

The significant advantage of investing in bonds is safety and stability. Here, the investors are aware of the interest they will receive at the end of the tenure. In comparison to other fixed saving options, investing in fixed rate bonds offer better returns. They serve as an investment avenue for parking money as per the investor’s requirements. The bonds can overcome the market volatility, i.e. in case of market recession. The bonds are less risky than  stock market instruments. Overall, this helps the investor to develop a better financial plan and align the same to the achievement of their financial goals.

Usually, the government and corporates issue bonds to raise funds from investors. Also, the Credit rating agencies rate these bonds based on their creditworthiness. However, corporate bonds are riskier than government bonds. Further, the low rated bonds are issued at high-interest rates where the risk attached is also higher.

Are bonds safer than stocks?

Usually, bonds are less volatile and safer in comparison to stocks. Bonds represent debt and stocks represent equity. Bonds are subject to fixed interest rate payment at the time of issuing the bond. Unlike stocks, there is no guarantee that the value of the stock will increase. The performance of the stock depends on the profitability and performance of the company. Also, the interest rate of bonds is higher than the savings accounts.

Furthermore, the creditors have a preference over the equity shareholders. For instance, if a company goes bankrupt, the creditors are paid first. In contrast, equity shareholders lose their entire investment.

In history,  stocks have outperformed bonds in the long run. However, bonds also have outperformed stocks in the specific economic cycle, usually during the bear market cycle. Therefore, investors must decide their allocation towards bonds and stocks wisely. The allocation should be decided based on their financial goals and requirements.

Can Bonds lose money?

Usually, bonds are considered as a risk-free investment. The reason is there is a guarantee of principal payment and interest rate payment on the maturity. However, one can also lose their money in case of selling the bond before maturity. The losses are subject to the selling price of the bond and the penalty mentioned in the bond agreement. Also, the investor may lose money from the bond in case the issuer defaults the payment. Hence, the investor needs to check the credit rating of the bonds before investing in them.

Published on November 9, 2020