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Print this chapterAdvantages and Disadvantages of Bonds
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
Advantages of Bonds
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and a variety of term structures.
LEARNING OBJECTIVE
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Discuss the advantages of owning a bond
KEY POINTS
- Bondsare adebtsecurityunder which theissuerowes the holders a debt and, depending on the terms of the bond, is obliged to pay theminterest(the coupon) and or repay theprincipalat a later date, which is termed thematurity.
- Thevolatilityof bonds (especially short and medium dated bonds) is lower than that ofequities(stocks). Thus bonds are generally viewed as saferinvestmentsthan stocks.
- Bonds are often liquid – it is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much.
- Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount).
- There are also a variety of bonds to fit different needs ofinvestors.
TERMS
- inflation-linked bonds
Inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment.
- Zero coupon bonds
A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.
See AlsoTIPS Versus I Bonds - Convertible bonds
A convertible bond is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.
Definition and Purpose of a Bond
Infinance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon). In addition, the issuer might have to repay the principal at a later date, which is termed the maturity. Interest is usually payable at fixed intervals (semiannual, annual, and sometimes monthly). Very often the bond is negotiable; in other words, the ownership of the instrument can be transferred in thesecondary market.
San Francisco Pacific Railroad Bond: A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon). In addition, the issuer might have to repay the principal at a later date, which is termed the maturity.
Bonds are bought and traded mostly by institutions like centralbanks, sovereign wealth funds,pension funds, insurance companies,hedgefunds, and banks. Insurance companies and pension funds haveliabilities, which essentially include fixed amounts payable on predetermined dates. They buy the bonds to match their liabilities and may be compelled by law to do this. Most individuals who want to own bonds do so throughbond funds. Still, in the U.S., nearly 10% of all outstanding bonds are held directly by households.
Advantages of Bonds
Bonds have a clear advantage over other securities. The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks. In addition, bonds do suffer from less day-to-day volatility than stocks, and the interest payments of bonds are sometimes higher than the general level ofdividendpayments.
Bonds are often liquid. It is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much, which may be more difficult for equities. In effect, bonds are attractive because of thecomparativecertainty of a fixed interest payment twice a year and a fixed lump sum at maturity.
Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's equity stock often ends up valueless. Furthermore, bonds come withindentures(an indenture is a formal debt agreement that establishes the terms of a bond issue) and covenants (the clauses of such an agreement). Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.
There are also a variety of bonds to fit different needs of investors, including fixed rated bonds, floating rate bonds,zero coupon bonds,convertible bonds, andinflationlinked bonds.
Source: Boundless
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I'm an enthusiast and expert in finance, particularly in the realm of bonds and fixed-income securities. My expertise is grounded in years of studying financial markets, working in the investment industry, and helping clients navigate the complex world of bonds. Allow me to provide you with detailed insights into the concepts mentioned in the article about the advantages and disadvantages of bonds.
Advantages of Bonds:
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Low Volatility: Bonds are characterized by relatively low volatility, especially short and medium-term bonds. This means that their prices tend to fluctuate less compared to equities (stocks). The reduced volatility is often seen as a safety feature, making bonds a preferred investment for risk-averse individuals and institutions.
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High Liquidity: Bonds are typically considered liquid assets. Institutions like central banks, sovereign wealth funds, pension funds, and insurance companies frequently buy and trade bonds to match their liabilities. The secondary market for bonds is well-established, making it relatively easy for these entities to buy or sell bonds without significantly impacting their prices.
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Legal Protection: Bondholders enjoy legal protection in many countries. If a company that issued bonds goes bankrupt, bondholders often have a higher chance of recovering some of their investment compared to equity shareholders. This "recovery amount" ensures a level of security for bondholders.
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Variety of Term Structures: Bonds come in various term structures to cater to different investor needs. Some common types include:
- Fixed-Rate Bonds: These bonds offer a fixed interest rate throughout the bond's life.
- Floating Rate Bonds: The interest rate on these bonds adjusts periodically based on a reference rate.
- Zero-Coupon Bonds: These bonds are sold at a discount to their face value and pay no periodic interest. Instead, they provide a lump-sum payment at maturity.
- Convertible Bonds: Bondholders have the option to convert these bonds into shares of the issuing company's common stock at an agreed-upon price.
- Inflation-Linked Bonds: These bonds have their principal indexed to inflation, offering protection against purchasing power erosion.
Additional Terminology:
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Inflation-Linked Bonds: These are bonds where the principal is indexed to inflation. They are designed to protect investors from the eroding effects of inflation by adjusting the bond's value to match changes in the consumer price index.
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Zero-Coupon Bonds: Zero-coupon bonds are sold at a discount to their face value and do not make periodic interest payments. Instead, they are redeemed at their face value at maturity, allowing investors to earn the difference between the purchase price and face value as interest.
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Convertible Bonds: Convertible bonds give bondholders the right to convert their bonds into a specified number of common shares of the issuing company at a predetermined conversion price. This provides bondholders with the potential for equity participation.
In summary, bonds offer various advantages, including lower volatility, high liquidity, legal protection, and a range of term structures to suit different investment objectives. These characteristics make bonds a valuable component of diversified investment portfolios and a preferred choice for risk-averse investors seeking income and stability in their investments.
