When an organization wants to raise money, one option is to sell a bond. Instead of going to a bank and getting a loan, the organization asks investors for a loan and promises a rate of interest. If people think the loan seems risky, they will require a high rate of interest to secure the loan.
However, bonds are, indeed, less risky than stocks. First of all, whereas a bond holder is guaranteed a return of face value upon the maturity of that bond, stocks carry no such guarantee of return to their holder. Because the stock market fluctuates rapidly, it is very important that citizens choose their investments wisely. Though the riskier investments offer higher paying dividends, these investments put the shareholder at much more risk to lose all that they have payed in to the fund. While it does pay off in some situations to take a bit of a risk, most people feel better about investing in something that they can only gain interest with. Though bonds may not pay as much as stocks in the beginning, they do guarantee that the investor will not have to absorb the whole of the loss should something go wrong. This school of thought is called limited liability, and is the premise that the corporation is based upon.
Second, with bonds, a holder is also entitled to a fixed rate of interest income. While stocks may give the holder a dividend at some point, this dividend is, by no means, a stipulation. These dividends are subject to the issuer's decision. While stocks may do very well one day, they may fall that much and more on the days after that rise. Therefore, bonds are a much more stable way to invest one's funds. Stocks may deliver quick rewards, but bonds tend to be worth the wait to minimize the risk of losing one's entire investment.
Third, all of these factors, as a whole, make the bond market infinitely more stable than the stock market. The stock market crash of 1929 tells us much of how quickly things can change in such a market. Though there were warning signs of this great problem's occurrence, those that put all of their savings into the market were devastated by the crash. It may look more lucrative to invest in something that gives a quick and ample return upon an investment; however, it may be well worth the wait to obtain the stability that the bond market offers. It all comes down to the premise of whether a person is willing to gamble with their savings. The balance between a possible quick return and a steady, accumulating return can be, at times, difficult to discern.
In addition to these factors, there are also different types of bonds, classified according to their risk and yield. Yield is simply another word for the returns upon the investment made. According to the Securities Industry and Financial Markets Association, "Current" yield is a function of a bond's coupon rate, or the annual interest rate the issuer promises to pay the investor, stated as a percentage of the bond's face value, or "par", which is the amount that the issuer has promised to pay the investor upon maturity. Risks of Investing in Bonds
Perhaps the least risky bonds are those that are issued by the U.S. Treasury. The risk factor of all bond investments are made relative to these "riskless" bonds. These bonds are backed by the full faith and credit of the United States government, and therefore carry essentially no risk of loss. Relative yields may be differentiated depending on the type of the bond issued, the current state of the economy, the credibility of the issuer and the specific type of the bond, itself.
One general rule of thumb is that the bonds that have long-term duration will generally have a much higher yield than those that only last 3 years or so.
According to the Securities Industry and Financial Markets Association, while bonds may be one of the most stable investment options available, they are still subject to some types of risk. One such risk is the fact that the bond market as a whole could decline, thus devaluing each and every bond, regardless of its "fundamental characteristics." Another risk involves interest rates. Interest rates values have an inverse relationship with bond values. When interest rates rise, the value of bonds fall.
In addition to these risks, there are a few others that should be mentioned. One of these is inflation risk. Because this type of a change in currency value affects everything around us, it, therefore, also must affect bonds.
The Securities Industry and Financial Markets Association also lists several other types of risks that bonds may be subject to.
In conclusion, though bonds may have a slower return upon investments made, they do offer a stability that is highly valued by many investors today.