Bonds are fixed-income investments issued by corporations and governments. Investors become creditors, essentially lending money to the issuers as they try to raise money. In return for the investments, bond issuers make interest payments on the principal at regular intervals until the bond reaches maturity. At this time, the issuer repays the bondholder the principal balance.
Because they are considered safe investments, bonds often come with low yields. These low interest rates are often considered unappealing by investors who seek strong returns or yields. This is especially true for government-backed bonds, which normally offer low returns. These low returns are a major reason why certain investors don’t want to invest in bonds in a low interest rate environment, relative to stocks and other securities.
Another potential detractor is that in a low-rate environment, rates have much more room to move up than down (since rates are nominally bounded by 0%). If interest rates rise, the market price of bonds will fall, causing losses among bond holdings.
Key Takeaways
- Bonds are debt securities issued by corporations and governments.
- They are considered to be lower risk than stocks but they also come with lower rewards.
- They may become less attractive to investors than other asset classes in low interest rate environments.
- Bonds typically have lower yields, but the returns are more consistent and reliable over a number of years than stocks, making them appealing to some investors.
- Stocks may provide greater returns than bonds but the risk of loss is usually higher.
Risk and Reward in the Financial Markets
It’s often not until after an investment in the stock market goes wrong that investors realize how risky stocks can be. The underlying concept of this idea is the willingness of an investor to take on risk to reap a potentially greater reward.
This is one of the most basic tenets of the financial markets. The more risk you take, the greater the compensation you receive. Investing in the stock market comes with considerably more risk than the bond market and, therefore, it generally provides greater returns for investors in the long run.
As such, many investors are more attracted to the potential double-digit returns that the stock market often produces. This isn’t the case with the debt market. That’s because there’s much more risk associated with the equity market. Bonds, on the other hand, are safer and provide investors with a great deal of protection for their principal.
Despite the perception, the bond market can be very profitable even if the associated returns are lower than those you’d see by investing in the stock market. The safety and consistency of bonds have value, particularly when bond investing is used to balance or offset riskier stock holdings.
Important
Asset allocation is the basis of structuring your investment portfolio. It is based on your age, risk tolerance, investment goals, and projected retirement age. It’s important to revisit the asset allocation as you get older to ensure you’re on track and to make sure you minimize your losses.
Bond Returns vs. Stock Returns
The impact of these greater returns is what affects the decisions that investors make when it comes to crafting their investment portfolios. Having said that, there’s no doubt about the fact that the possibility of earning a significantly higher amount of money certainly influences investors to place their money in the stock market.
But it is important to note that a double-digit return on stocks is far from guaranteed. And one of the things that investors often forget is the risk potential. With the chance of great rewards also comes the potential for loss. It is, after all, a double-edged sword.
Nevertheless, it is the prospect of huge gains over time that draws some people away from the bond market and more towards the stock market. But keep in mind that investing in safe vehicles like bonds allows you to offset any of the losses that you may experience. And if nothing else, you earn steady and guaranteed returns even if they aren’t as glamorous as those offered by stocks.
Example of Bond and Stock Returns
Here’s a hypothetical example to show the difference between the returns offered by the bond and stock markets using an initial investment of $10,000.
Imagine that you were able to invest in the bond market and earn 5% on your initial investment every year for 30 years. In this case, your investment would grow to $43,219 by the end of that period.
On the other hand, if you were to invest in the stock market, which provides a higher return of, say, 10%, that initial $10,000 would grow to $174,494 or just over four times as much (20% would get you $2.4 million).
How Do Bonds Relate to Interest Rates?
Bonds and interest rates have an inverse relationship. When interest rates rise, the price of bonds decreases. Conversely, if rates decrease, the price of bonds increases. This is because if interest rates increase, investors will look to newer bonds that pay a higher fixed interest rate. This makes the current bonds unattractive because they pay a lower rate. To make them more attractive, the price has to come down.
Are Bonds a Good Investment?
Yes, bonds are a good investment, but with every investment decision, it’s important to take stock of your investment goals and risk tolerance. Bonds are safer than stocks but typically do not provide as high of a return, depending on the bond. They can be part of a diversified portfolio, especially when looking to reduce risk; that being said, they won’t provide high returns like stocks generally do. Bonds are a particularly good investment when interest rates are higher, as the bonds will pay out more than in a low-rate environment. Overall, bonds can be a good addition to an investor’s portfolio.
Are Bonds FDIC Insured?
No, bonds are not insured by the Federal Deposit Insurance Corporation (FDIC). Bonds are like many other investments and the risk is on the investor. The FDIC does insure checking accounts up to $250,000.
The Bottom Line
When you compare the two, the returns offered by the bond market pale in comparison to those offered by the stock market. But remember: Returns offered by equities are never guaranteed and the risk for loss is just as high as the chance for gains. Investing in bonds, though, can provide a guaranteed source of income while offering you safety and protection for your principal investment.