One of the most common usages of bonds is to preserve principal. While this concept works excellently with bonds that are perceived to be risk-free, like short-term US government Treasury bills, investors can use it with other types of bonds as well. Removing the chance of any disastrous events, bonds are effective when it comes to preserving principal.
Since bonds are essentially debts with scheduled repayments and maturities, lenders (bondholders) can expect their bonds to retain value and terminate at par upon maturity.
A risk-free bond bought at par and held to maturity should preserve principal, mature at par, and provide a dependable cash flow.
Saving for the future has historically been one of the best purposes of bonds. Savings bond provide one of the most secure and time-tested approaches to long-term saving.
They are guaranteed by the full faith and credit of the US government and are sold in various formats, including discount and interest-pying formats. Savings bonds are created to be held to maturity and are usually given as gifts to young investors to help them learn something about saving.
Managing Interest-Rate Risk
Interest-rate risk is the risk inherent in all kinds of bonds that the price of the bond will fluctuate with prevailing rate. This risk exists since a bond’s priced value is the culmination of the present value of the future interest payments and returned principal upon maturity.
And due to this valuation, there is an inverse relationship between the bond’s current price and the prevailing rates.
For instance, when the current rates increase, all things considered, the price of the bond should be falling. This is a very simplified instance of the relationship between interest rates and bond prices and applies to the highest-quality bonds first.
Diversification is usually the most overlooked use of bonds. Bonds have a generally low correlation with other asset classes, and this makes them an excellent diversification tool.
For instance, you can create a simple portfolio of large cap stocks and US government bonds where the cross-correlation between the assets is usually less than 1.
Even though it’s rare to find which assets are perfectly negatively correlated, the diversification between bonds and stocks can help smooth out those volatile market swings, particularly during flights to quality.
One of the benefits of bonds over other asset classes is that they have predictable stream of income that can be used to fund future expenses for individuals and corporate pension obligations for institutions.
This is one of the reasons why financial institutions, such as banks and insurance companies, use long-term bonds for their long-term planning.
Bonds let them match their assets liabilities with a much higher degree of certainty than with other asset classes.
People usually use bonds to match future expected cash need. Institutions also use this strategy on a more complex basis called immunization. The concept assumes a match of the duration of the bond to the expected cash flow, which can be easily accomplished by using a zero-coupon bond in which the maturity matches the bond’s duration. While this will not provide any income over the life of the bond, it will still provide a direct match.