Bonds are an important component of most investment portfolios. Bonds reduce the overall risk of a portfolio by introducing diversity. Bonds produce steady current income—income that investors receive each month. This steady stream of income is important to some investors, depending on their current needs. Bonds are relatively safe investments if they are held to maturity because it is possible to calculate exactly how much interest they will earn. Bonds are lower-risk investments than stocks; however, the returns on bonds are lower as well. Bonds are attractive options when the market anticipates lower interest rates. As interest rates drop, bond values rise.

Although there are many advantages to investing in bonds, there are also several disadvantages. Bonds are less liquid than other types of assets: an investor may be unable to find a buyer or seller for a bond. Another disadvantage is that bonds are often sold in large amounts—amounts that are larger than most investors can afford to invest. Bonds may also be called, which means that the issuing company may force you to redeem your bond before you had planned to redeem it. This generally happens when current market interest rates are lower than market rates were when the company initially issued the bonds. The company will call the bonds and reissue new bonds at lower rates, which will save the company money on interest. Additionally, it may be difficult to find a good investment outlet for the interest yielded from your bonds, particularly if interest rates are declining.

Bonds and Risk: All Risk Is Not Equal

Bonds are susceptible to a number of risks. These risks include the following:

• Interest-rate risk: Interest rates may rise or fall at any time, resulting in a decline or increase in a bond’s value. Rising interest rates require that future cash flows have a higher rate of return. Since future cash flows are fixed in bonds, the principal value of the bond must be decreased to compensate for a higher required return.
• Inflation risk: A rise or decline in inflation may result in an increase or decrease in the value of a bond. For most bonds, a higher rate of inflation results in a less valuable bond. The inverse of this situation is also true. Rising inflation rates require that future cash flows have a higher rate of return, which lowers the present value of a bond.
• Company risk: The bond price may rise or decline because of problems with the company that is offering the bond. The better the future prospects for a company, the lower the required rate of return by investors, and the higher the present value of a bond. The inverse of this situation is also true.
• Financial risk: Whether or not a company is viewed as a financial risk has the potential to affect the performance of the company’s bonds. Companies that are less risky or have better prospects can usually borrow money at lower rates of interest; hence, these companies have lower expenses and higher earnings. The inverse of this situation is also true.
• Liquidity risk: Investors take the risk that they may be unable to find a buyer or seller for a bond when they need one. Often, liquidity is more closely related to market conditions than company conditions.
• Political or regulatory risk: Unanticipated changes in the tax or legal environment may have an impact on a company. Since taxes and the legal environment affect the outlook for a company, any regulatory changes that improve a company’s long-term prospects will generally result in a higher price for that company’s bonds. The inverse situation is also true.
• Exchange-rate risk: Changes in exchange rates may affect profitability for international companies. As exchange rates strengthen, the cost of domestically produced goods that are sold overseas increases. The inverse situation is also true.