The most popular investment alternatives include bonds, which give investors set profits in certain periods. However, there are other fixed-income instruments that could benefit them. Which one is the best of all? How can you know which option you should choose to guarantee wealth in the future?
From bond funds to preferred stocks, all fixed-income investment alternatives are different. Each promises advantages and disadvantages for those who want to avoid the risks and price fluctuations associated with other financial instruments.
Do you want to find more information about them? Here’s a comparison between bonds and the most common fixed-income securities, so you can understand each one’s behavior, benefits, and cons. Keep reading!
What Are Bonds?
When it comes to fixed-income investments, most people think about bonds. These instruments represent a loan that, as an investor, you can make to a borrower. Depending on the type you choose, a company or the government usually acts as a bond issuer.
Buying a bond means that you are lending a certain amount of money to an entity. During the process, both parties must agree on the interest payments and the maturity date.
Once the maturity date is attained, the borrower must pay back the full amount. In some cases, the final payment is made with a part of the profits. Overall, an investor can benefit from bonds’ performance, as they can obtain interest payments from time to time and recover their initial capital. However, bond prices can also fluctuate and gain or lose value as US interest rates rise or fall.
Types of Bonds
In order to choose the best investment option, you should also know the types of bonds that exist. These are the most common:
As the definition above indicates, a corporate bond refers to a loan you make to a company for a certain period. However, these alternatives are subject to credit risk, as borrowers could avoid interest payments or the initial amount’s return if they file for bankruptcy. In other words, these bonds’ safety depends on the firm’s financial strength and creditworthiness. These are divided into:
Investment-grade bonds (when they have high credit quality)
Also known as government bonds, these are debts issued by the government for specific purposes, such as raising money. When you buy these assets, you make a loan to the federal government called “principal.” Generally, a Treasury bond is issued for 30-year terms with semi-annual interest payments.
Like the debts issued by the federal government, municipal bonds are low-risk options since they are backed by states, cities, municipalities, or counties to finance public works. In these cases, investors lend money to local governments and often receive interest payments every six months before the full principal.
What Are Fixed Income Securities?
A fixed-income security is a debt instrument issued by a public or private entity, including governments or corporations, to finance projects or expand their operations. Investors can earn money through fixed periodic payments on set dates (agreed by both parties) and the provincial’s return at maturity. As you can see, this description matches the definition of bonds because these alternatives fall into this investment category.
You can generate income through fixed-income securities because they provide a stream of regular payments. Bonds are the most common option in this group. However, not all bonds are the same. In addition, each fixed-income instrument has its own characteristics. In this sense, these are the most popular types of fixed-income securities:
Treasury notes and bills
Certificate of deposit (CD)
Fixed-income mutual funds, including bond mutual funds and money market funds
All types of fixed-income investments are subject to risks. These are the most common:
Interest rate risk: Their prices often fall when interest rates rise. Actually, the main cause behind bond market volatility is usually linked to interest rate movements.
Inflation risk: Bond investors may also lose purchasing power if the inflation rate exceeds the fixed amount they receive at regular intervals from interest payments on the debt.
Liquidity risk: It defines the scenario in which an investor wants to sell a fixed-income asset but cannot find a buyer.
Credit risk: It refers to the possibility that a bond issuer will not meet its debt obligations. In these cases, investors may not receive scheduled payments or the full value of their principal investment.
Treasury Bills and Notes: Are They the Same as Treasury Bonds?
Although treasury bills and notes are types of bonds, there are some differences between the two groups. T-notes are issued by the US Treasury and often have a face value of $1,000 but can mature in short terms, ranging from two to five or 10 years, and pay interest every six months at fixed coupon rates. In contrast, T-bills pay no interest, can be purchased for less than their face value, and are due within a year.
Since Treasury bonds have a longer maturity period, they tend to pay a higher interest rate and generate more income in the long term. However, T-bonds’ costs vary more because their maturity time frame is longer.
Bonds Compared to Other Fixed-income Securities
As you can see, Treasury bills and notes are types of bonds with only a few changes. However, other fixed-income instruments have important differences. Here’s a comparison between bonds and other common investment alternatives.
Bonds Vs. Certificate of Deposits (CDs)
Also known as CDs, certificates of deposits are issued by banks or credit unions. They are similar to savings accounts but are subject to slightly higher interest rates. When you buy CDs, you allow financial institutions to use your money for a specific period, ranging from six months to 10 years.
A certificate of deposit can be as safe as an investment since there is no credit risk. Moreover, the Federal Deposit Insurance Corporation (FDIC) ensures that an investor can recover up to $250,000 of their principal even if the bank fails. However, CDs can be affected by inflation. In addition, while a higher percentage usually translates into higher interest rates for a better yield, securing money at low-interest rates is challenging.
Key Differences: Are Both Safe-haven Investment Options?
Like bonds, certificates of deposit are considered safe investments, as they offer modest returns with little or no risk of principal loss. However, both have fundamental differences that you must understand in order to know which is the best option. These are:
Bonds are available through the US Treasury or brokerage firms, while CDs are issued through banks and brokerage firms.
While both instruments are secured, the CDs are insured for up to $250,000. Government bonds are also considered safe-haven investments, but those issued by corporations are subject to credit risk.
Bonds are great long-term options when interest rates are low. On the contrary, it is not advisable to buy a long-term CD in that scenario.
Early bond sales may cause a loss of value or future interest payments. If you cash your CDs in before the redemption date, the bank can impose penalties that take a fraction of the principal or wipe out most of the proceeds.
Bonds Vs. Preferred Stocks
Also known as preferred shares, these instruments give holders ownership or equity in a company. You can buy both common and preferred stocks. Common shares give holders the right to vote to elect a board of directors or on company policy.
In terms of dividends and other payments, preferred stock owners have more advantages. Therefore, they can enjoy a better return than common stockholders. However, preferred stock excludes many rights, including voting.
Key Differences: Which Generates More Profit?
Bonds and preferred stocks are sensitive to interest rate movements and do not offer voting rights to a company’s shareholders. However, there are key differences between them, including:
When a company goes bankrupt and is forced out of business, bonds take precedence over preferred stock, since interest payments are legal obligations paid before taxes. Instead, dividend payments are made after taxes and are not mandatory if the company runs into financial trouble.
Preferred stocks are riskier than bonds.
To offset the increased risk, preferred stocks offer higher returns.
Preferred stocks often have a lower face value than bonds. Therefore, they require a lower minimum investment amount.
Bonds Vs. Debentures
Overall, debentures are types of bonds with more specific purposes. Both are used to raise capital, but debentures usually intend to cover expenses for an upcoming project or planned business expansions.
Debentures, a common form of long-term financing for businesses or corporations, have a floating coupon rate. They are also known as revenue bonds because issuers expect to pay the interest on the loans with the income derived from the financed project. Companies can pay the principal in a lump sum or through an installment plan.
Key Differences: Understanding Unsecured Bonds
Although all debentures are bonds, not all bonds are debentures. Furthermore, both instruments differ in terms of collateral requirements, issuer, and level of risk. These are the key aspects:
While bonds are often secured by some type of collateral, debentures can be secured or not secured.
Bonds can be issued by financial institutions, government agencies, and large corporations. However, debentures are available in private companies in most cases.
Debentures can be riskier since, unlike bonds, they are not backed by collateral but by the issuer’s faith and credit.
Bonds. Vs. Bond Funds
Do you plan to invest in bonds to diversify your portfolio? You can choose between individual bonds and bond mutual funds. The former are the ones that allow you to lend an amount of money to a company or corporation and receive interest payments in intervals before the total principal.
However, bond funds are not well-known in the investment community. Unlike individual ones, bond mutual funds hold a large number of assets with different maturity dates, interest rates, and credit ratings.
Also, bond funds usually require monthly distributions. Payments can be made directly to investors or reinvested in bond funds to compound returns. These instruments offer different benefits, including:
Bond funds facilitate diversification per dollar invested, as they give exposure to a basket of bonds within the fund.
Those who buy bond funds often receive better prices on bonds than investors who opt for individual assets.
Bond funds could increase yields and income if you manage them proactively and buy or sell according to movements in the interest rate.
They are also subject to interest rate risk. Therefore, bond prices in a mutual fund may fall when the percentage rises.
However, bond mutual funds can also have some drawbacks, including management fees, fluctuating net asset values, and tax consequences for different cost bases.
When you actively trade a bond fund, management fees can be higher, and yields can go down, for example. Also, you should keep in mind that bond funds can go down or up when interest rates rise or fall, respectively.
Key Differences: Is There Interest Rate Risk for Bond Funds?
Although bond mutual funds encompass individual assets, including corporate bonds, they are not the same. These are the most important differences:
Bond funds are professionally managed. However, individual bonds are often in the hands of investors.
Unlike individual bonds, if you buy bond funds, there is no guarantee that you will get your principal back in a specific period.
Investment amounts for bond funds can be small.
Bond funds’ management fees vary depending on the share class.
When you invest in a bond fund, you often receive income monthly.
Bond funds’ coupons can be reinvested.
If you want to have a broader investment, bond funds offer greater diversification.
Market conditions could affect bond funds’ value. In contrast, an individual bond does not usually succumb to bond market risk if you buy it and hold it until maturity.
Final Thoughts: Should You Choose a Bond Fund or Other Fixed-Income Instrument?
Picking the best option among all the fixed-income alternatives depends on several factors, including your investment objectives, risks, charges, and expenses. A bond fund may be the ideal option if you are looking for diversification, as they invest in many individual securities for a small minimum.
However, a bond fund is not the best alternative for those who want to be 100% sure that they will recover their capital and hope to ensure a fixed income stream in specific periods. The same is true for other instruments. Preferred stocks generate more returns than non-bonds, for example.
In either case, before making a decision, you should analyze all the available options and choose the one that best suits your goals. Remember that your hard-earned money must go to a place where it can multiply!