Two investment options that may come across your path are bonds and listed investment companies (LICs). While both can play important roles in an investment portfolio, they operate differently.

Why compare these two? Well, they both offer ways to diversify your portfolio and potentially earn income. However, their structures, risk profiles, and potential returns are different.

So how do they stack up against each other? In this article, we'll explore how bonds and LICs work, look at their pros and cons, and compare the two options. We’ll also consider how they might fit into various investing strategies. We won't tell you which is better – that's your call. But we'll arm you with the knowledge to make an informed decision.

Let’s take a closer look.

What are bonds?

Bonds are a type of investment where you lend money to an entity, such as a government or company. In return, the entity promises to pay you back with interest over a set period.

How bonds work

Bonds work by paying you regular interest, known as coupon payments. When the bond reaches its maturity date, you get back your initial investment. This amount is also known as the bond's face value, or par value.

Potential benefits of investing in bonds

Investing in bonds offers several benefits that can potentially complement your investment strategy. Here are some key advantages:

• Regular income : Bonds usually provide a steady stream of income through interest payments. This can be attractive for investors seeking predictable returns.
• Capital preservation : Bonds are generally considered safer than stocks . They can help preserve your initial investment, especially with high-quality government or corporate bonds.
• Diversification : Adding bonds to your portfolio can reduce risk. They often perform differently from stocks, providing balance and a degree of stability.
• Predictable returns : Bonds have fixed interest rates and maturity dates. This predictability can make it easier to plan your financial future.
• Lower volatility : Bonds typically experience less price fluctuation compared to shares. This can make them a more stable investment choice during market turbulence.
• Tax benefits : Some bonds, such as municipal bonds, may offer tax advantages. Interest from these bonds can be exempt from certain taxes.

Considering these benefits, bonds may play a useful role in a diversified portfolio. But it’s important to note that while bonds offer these potential benefits, they also come with risks and may not be suitable for all investors.

Risks of investing in bonds

Investing in bonds, like any investment, comes with certain risks. Here are some to consider:

• Interest rate risk : When interest rates rise, bond prices typically fall. This can lead to a loss if you sell the bond before it matures.
• Credit risk : If the issuer of the bond faces financial difficulties, they may default on their payments. Government bonds generally have lower credit risk compared to corporate bonds.
• Inflation risk : Inflation can erode the purchasing power of the interest payments you receive. This risk is higher with fixed-rate bonds.
• Liquidity risk : Some bonds may be harder to sell quickly without losing value. This can be a concern if you need to access your money quickly.
• Call risk : Some bonds can be "called" or repaid early by the issuer. This can happen when interest rates drop and can lead to reinvestment at lower rates.
• Market risk : Bond prices can fluctuate due to changes in the market or economic conditions. This can affect the value of your investment if you need to sell before maturity.

The impact of these risks can vary depending on the type of bond, economic conditions, and individual financial circumstances. Consider how these risks align with your risk tolerance and investment goals.

What are listed investment companies (LICs)?

LICs are a type of investment vehicle that pools money from shareholders to invest in a diversified portfolio of assets. They are publicly traded on the stock exchange, like the Australian Securities Exchange (ASX) , allowing investors to buy and sell shares easily.

Each LIC has its own investment strategy and focus. Some specialise in specific sectors or regions, while others aim for broad market exposure.

How LICs work

LICs are structured as companies and managed by professional investment managers. These managers decide where to invest the funds, to achieve specific investment objectives, such as income generation or capital growth. This active management approach aims to produce returns that may outperform the broader market.

LICs manage a diverse range of investments, which may include Australian shares, international shares, fixed income and property. Investors receive dividends from the profits made by the LIC.

Potential benefits of investing in LICs

Investing in LICs can potentially offer several advantages that can add to your investment portfolio. Here are some key benefits:

• Diversification : LICs invest in a wide range of assets, spreading risk across various investments. This diversification can help reduce the impact of poor performance from any single investment.
• Professional management : LICs are managed by experienced investment professionals who make informed decisions on your behalf. This can be beneficial if you lack the time or expertise to manage your investments actively.
• Regular income : Many LICs aim to provide consistent dividend payments to shareholders. This can be a reliable source of income, particularly for income-focused LICs.
• Ease of access : LICs are traded on the stock exchange, making it easy to buy and sell shares. This liquidity allows you to adjust your investment position as needed.
• Potential for capital growth : LICs that invest in growth assets can offer the potential for capital appreciation over time, helping you build wealth.
• Lower costs : Compared to some managed funds , LICs often have lower management fees. This can be cost-effective, especially for long-term investors.
• Transparency : As publicly listed entities, LICs are required to provide regular updates and reports. This transparency helps you stay informed about your investment's performance and management decisions.

Bear in mind that these benefits can vary between different LICs and may not apply in all market conditions.

Risks of investing in LICs

Before you jump into investing in LICs, note that it comes with certain risks, such as:

• Market risk : LICs are traded on the stock exchange, so their share prices can fluctuate based on market conditions. This can lead to losses if the market performs poorly.
• Management risk : The success of an LIC depends on the skills of its investment managers. Poor management decisions can negatively impact performance.
• Dividend risk : LICs aim to pay regular dividends, but there is no guarantee. If the LIC’s investments don’t perform well, dividend payments may be reduced or skipped.
• Liquidity risk : Although LICs are traded on the stock exchange, some may have lower trading volumes. This can make it harder to buy or sell shares quickly at your desired price.
• Fee risk : While LICs often have lower fees compared to some managed funds, management and performance fees can still impact your overall returns.
• Market sentiment : The share price of an LIC can be affected by investor sentiment and market perception, sometimes unrelated to the actual performance of the underlying assets.
• Economic risk : LICs invest in a variety of assets, which can be affected by economic changes. Factors such as interest rates, inflation , and economic downturns can impact the performance of these assets.

As with any investment, it's crucial to understand these risks in the context of your financial situation and goals. Do your research when evaluating LICs as an investment option.

What are the key differences between bonds vs LICs?

Now that we understand bonds and LICs a little better, let’s look at how they stack up against each other.

Bonds and LICs have several key differences as investments, the main one being they belong to different asset classes. Bonds are considered fixed income (with regular income payments) and LICs are considered equity (ownership stakes in companies).

Here are other differences to note:

Attribute	Bonds	LICs
Income generation	Regular interest payments	Can pay dividends from profits
Capital growth	Return of initial investment at maturity, with little opportunity for capital growth	Potential for capital appreciation over time
Risk factors	Generally lower risk, especially government bonds	Can carry higher market risk, depends on investments
Liquidity and tradability	Can be sold before maturity, not always easy to trade	Usually easy to trade on the stock exchange
Tax considerations	Interest is usually subject to income tax	Dividends are subject to tax but may come with franking credits which offer tax benefits
Management	No active management required	Actively managed by professional managers
Investment horizon	Suitable for short-to-medium term	Better suited for long-term investment

This comparison highlights that bonds and LICs serve different purposes in an investment portfolio. Bonds typically offer more stability and income certainty, while LICs provide the potential for higher returns with increased risk. Knowing these differences can help you decide which investment suits your needs.

Long-term investing with bonds vs LICs

Both bonds and LICs can play important roles in a long-term investment strategy.

Investing with bonds

Bonds offer stability and regular income and are preferred by investors who don’t want to take on much risk. They can help preserve capital and provide predictable returns. Bonds can also balance riskier investments in your portfolio, providing a steady income stream over the long term.

Here’s a fictional example to bring this to life:

Sasha focuses on preserving her capital and generating steady income. She invests in a mix of government and high-quality corporate bonds. Over 20 years, Sasha enjoys regular interest payments, which supplement her salary. She appreciates the stability and predictability bonds offer.

As a risk-averse investor, Sasha’s mind is at ease knowing her principal investment is relatively safe. She plans to use the interest payments to cover expenses in retirement. Sarah understands that bond returns are generally lower than shares, but values the lower risk.

It’s important to note that Sasha’s investment experience is specific to her situation. Bond investments carry risks, including interest rate and credit risks. Past performance also doesn’t guarantee future results.

Investing with LICs

LICs are designed for growth and income and can appeal to investors with a longer time horizon. They offer diversification and professional management. This can potentially enhance returns and reduce risk. LICs invest in various assets, aiming for capital growth and dividend income.

Let’s look at an LIC investing example:

Zeke aims for long-term growth and income. He invests in several equity-focused LICs, which provide diversification and professional management. Over 15 years, Zeke sees his investment grow in value and enjoys regular dividends.

Zeke’s LICs invest in a broad range of companies, helping spread risk. He reinvests the dividends to buy more shares, benefiting from compound growth. Zeke values the potential for capital appreciation and the ease of trading LIC shares on the stock exchange.

Remember, Zeke’s investment experience is specific to his situation and there’s a risk of capital depreciation with LICs. Again, past performance doesn’t guarantee future results.

Choosing both bonds and LICs

What if you like the sound of both bonds and LICs?

The good news is, they’re not mutually exclusive – you can invest in both. Including both bonds and LICs in your portfolio can provide a mix of stability, diversification and growth. This combination can potentially help manage risk and achieve balanced, long-term returns.

How can I invest in bonds and LICs?

There are several ways you can buy bonds and LICs, here’s how:

Buying bonds

Buying LICs

Through a broker: You can buy bonds through a financial broker. They can help you choose from a variety of government and corporate bonds. Directly from the issuer: Some government bonds are available for purchase directly from the government’s website. This method often involves lower fees. Bond ETFs : Bond exchange-traded funds (ETFs) allow you to invest in a diversified portfolio of bonds. You can buy and sell bond ETFs on the stock exchange through a brokerage account. Bond funds: You can also invest in bonds through bond funds, which pool money from many investors to buy a diversified portfolio of bonds. These are available through brokers or fund managers.

Through the stock exchange: LICs are listed on the stock exchange, so you can buy and sell shares like any other listed company. Use a brokerage account to place your order. During an IPO: When a new LIC is launched, it may offer shares through an initial public offering (IPO) . You can participate in an IPO through your broker. Managed accounts: Some investment managers offer managed accounts that include LICs. They handle the buying and selling for you, providing professional management of your investments.

Before buying, research the bond issuer or LIC manager, their track record, and the underlying investments. This helps you understand the risks and potential returns.

Bringing it all together – bonds vs LICs

Bonds and LICs both offer valuable opportunities for long-term investors. Bonds provide stability and regular income, making them a relatively safe choice for investors who prefer less risk. LICs, with their potential for growth and dividends, may suit those looking for active management and diversification.

Whether you choose bonds, LICs, both or neither, consider your investment objectives and strategy. And it doesn’t hurt to get professional advice along the journey to achieving your financial goals .