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Why Do Investors Choose Bonds?

Bonds tend to be less volatile than stocks and are often chosen to help diversify a portfolio, potentially mitigating investment risk. But is this enough to justify picking them over other investment opportunities?

Image Credit: Fernando Zuleta (click for detail)

Bonds As Bulls

Bonds can also offer lower total returns than stocks over the long term, although corporate bonds outpaced stocks by, on average, 4% per year between 2002 and 2011.

It is important to note that this period included some tough times for stocks - and interest rates have been uncommonly low - which can increase bond prices. Also keep in mind that past performance does not guarantee future results. If interest rates rise over the next few years, bonds could return substantially less than stocks.

Even so, the last decade has shown that sometimes bonds can be bullish.


Becoming a Lender

When you purchase a bond, you are lending money to the bond issuer in exchange for the issuer’s promise to repay the loan amount plus interest at a future date. Bond maturities usually range from 30 days to 30 years.

Bonds are issued by federal, state, and local governments and by corporations. U.S. Treasury bonds are typically considered among the safest investments, despite the recent downgrading of the nation's credit, as U.S. Treasuries are guaranteed by the federal government as to the timely payment of principal and interest. The return on municipal bonds tends to be lower than that of federal bonds, although the interest on bonds issued by your own state or local government frequently has the advantage of being free from federal income tax.

Corporate bonds usually offer higher interest rates than government bonds with comparable maturities, though they come with a higher degree of risk. This is based on the creditworthiness of the companies that offer them. This risk may still be relatively low; a recent study found that the default rate for bonds issued by nonfinancial companies was just 0.3%, between 1946 and 2008.


Buying Bond Funds

Another way to incorporate bonds into your portfolio is by investing in bond mutual funds. There are almost 2000 bond funds available, representing around 25% of all mutual funds. They are subject to the same inflation, interest-rate, and credit risks as their underlying bonds. Bond funds can be bought and redeemed, in general, more easily than individual bonds. Furthermore, they have no specific maturity date.

In addition to helping diversify a portfolio, bonds can be used to help generate a regular income stream. The principal value of stocks, bonds, and bond funds will fluctuate with changes in market conditions. Shares, when sold, and individual bonds redeemed prior to maturity may be worth more or less than their original cost. Diversification does not guarantee against loss; it is a method used to help manage investment risk.

In some states, investors have to pay income tax if they buy shares of a municipal bond fund that invests in bonds issued by other states. Although some municipal bonds in a fund may not be subject to ordinary income tax, they may be subject to federal or state alternative minimum taxes. If a tax-exempt bond fund is sold for a profit, investors could incur capital gains taxes.

NB. Mutual funds are sold by prospectus. You should consider the investment objectives, risks, charges, and expenses carefully before investing.

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