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Individual investors seeking income, preservation of capital, capital appreciation, and diversification often consider adding bonds to their portfolios.
Unfortunately, they can be unaware of the potential risks associated with investments in debt instruments.
In this article, we’ll take a look at seven common mistakes and issues sometimes overlooked by fixed-income investors.
Key Takeaways
- Bonds and other fixed-income investments are often portrayed as more conservative and less risky than stocks, but they have specific risks.
- Uninformed investors can make costly mistakes when investing in the bond market.
- Interest rate volatility is considered to be the primary risk associated with bonds.
- If you plan to hold a bond until it matures, interest rate risk poses no threat (unless the bond is called).
- Investors also face risk from inflation because it can erode the value of income provided by bonds.
Bond Basics
Bonds are debt instruments. Debt instruments include fixed and variable bonds, debentures, notes, certificate of deposit, and bills.
Those who issue bonds are known as issuers and investors who buy bonds are bondholders. Bondholders act as lenders.
In return for their loaned money, bond issuers promise to pay lenders interest and the bond’s par value on a specific future date.
Debt securities are issued by governments and companies to raise funds to finance operations, activities, and projects. Companies that need such funds may choose to issue debt rather than shares of stock to avoid diluting the ownership percentages of existing shareholders.
Debt securities can offer different rates of return. The higher the rate, the greater the risk of financial loss.
Other important features of debt securities include:
- Coupon rate: The annual rate of interest to be paid to the bondholder.
- Maturity date: The date on which the security will be redeemed.
- Call provisions: The options the company has to pay back the debt before the maturity date.
Calls
Investors should understand how a bond’s call provisions work and the potential impact on them. (Look for the details in a bond’s prospectus.)
In general, a bond with a call can be redeemed by the issuer prior to the maturity date on the call date. That means the issuer will pay you back your principal early and stop all interest payments.
Issuers often call bonds when interest rates drop and they can issue new bonds (borrow money) at lower rates of interest.
So, the income you’re expecting to receive for perhaps years to come can dry up unexpectedly. You’ll get your investment money back but if interest rates have dropped, as is likely the case, you’ll have to invest it at a lower rate of interest.
Let’s now look at the seven mistakes bond investors often make.
1. Ignoring Interest Rate Moves
Interest rates and bond prices have an inverse relationship. As interest rates go up, bond prices decline, and vice versa.
This means that before a bond matures, the price of the issue may vary widely as interest rates fluctuate.
So if you plan to sell your bond before it matures, you may find that its price is less that what you bought it for, if rates have risen.
However, if you plan to hold the bond until maturity, you face no risk from a change in interest rates.
Bear in mind that, as with stocks, you don’t have to sell your bond investment to get your principal back or to realize a return. By holding it to maturity (as long as it’s not called or defaulted upon), you will receive all the interest to which you’re entitled and the bond’s par value.
2. Not Noting the Claim Status
Not all bonds are created equal.
Senior notes are often backed by collateral (such as equipment). They usually take precedence over other debt and bondholders’ payments should bankruptcy and liquidation occur.
Subordinated debentures are unsecured debt that is junior to other types of debt. Holders of subordinated debentures don’t get paid until the senior bondholders are paid in full.
Before you buy any bond, be sure you understand which type of debt you’re considering and the potential impact in case of bankruptcy. Again, look to the bond prospectus for this information. Your broker may also have the details.
3. Assuming a Company Is Sound
Despite a company having a solid reputation in the investment community, there is no absolute guarantee that a bond you’ve purchased will come through with interest payments or the return of principal. Investors should bear in mind that default is always a possibility.
Rather than simply assume that a bond investment is sound, review the company’s financial statements and look for any reason that it won’t be able to service its obligation.
Examine the income statement and then take the annual net income figure and add back taxes, depreciation, and any other non-cash charges.
This will help you to determine how many times that figure exceeds the annual debt service number. A figure of at least two times coverage can offer some assurance that the company has the ability to pay down its debt.
You can buy bonds when they’re issued (on the primary market) or on the secondary market through a broker, after they’ve been issued. Treasury bonds can be purchased directly from the U.S. government, or through a brokerage or bank.
4. Misjudging Market Perception
As alluded to above, bond prices can and do fluctuate. While interest rates play a role in that, another source of volatility is the market’s perception of the issue and the issuer.
If other investors don’t like an issue or think the company won’t be able to meet its obligations, or if the issuer suffers a blow to its reputation, the price of the bond can drop. The opposite is true if Wall Street views the issuer or the issue favorably.
A good tip for bond investors is to take a look at the issuer’s common stock to see how it is being perceived. If it is disliked, or there is unfavorable research in the public domain on the equity, that could spill over and affect the price of the bond, as well.
5. Failing to Check Past Performance
It is important for an investor to consider a company’s past performance for a history of solid earnings and to verify that it has made all of its interest, tax, and pension plan obligation payments.
Specifically, read the company’s management discussion and analysis (MD&A) section of an annual report. Also, read the proxy statement. Both can yield clues about problems a company may have had meeting its financial obligations.
They may also indicate future risks that could adversely impact a company’s ability to service its debt.
The goal of this due diligence is to gain information that a company has paid its debts in the past and is likely to do so in the future. Such research can confirm that the bond you may purchase is likely to be honored.
6. Ignoring Inflation Trends
When bond investors hear reports of inflation trends, they need to pay attention. Inflation can erode a fixed income investor’s future purchasing power.
For example, if inflation is growing at an annual rate of four percent, then each year it will take a four percent greater return to maintain the same purchasing power.
This is important, particularly for investors who buy bonds at or below the rate of inflation, because they are actually guaranteeing they’ll lose money when they purchase the security.
Nominal Yields and Real Yields
Take a moment and consider nominal yields and real yields. A nominal yield is the coupon rate—the rate the issuer promises to pay an investor for the life of the bond. The real yield is the nominal yield minus the inflation rate.
If you are considering or own a bond with a 6% nominal yield and the inflation rate is 3%, then your real yield, without inflation’s impact, is 3%.
If inflation drops, your real yield increases. If it rises, your real yield decreases. A higher coupon rate also helps maintain a higher real yield as long as inflation remains stable.
Corporate bonds usually offer higher yields than U.S. Treasuries because the former aren’t backed by the full faith and credit of the government.
In addition, specific high-yield bonds are worth considering but remember that the higher rate indicates a higher level of risk, so do your research.
Asset diversification also can help investors to defend against inflation. For example, including equities, with their historically higher rate of return, along with bonds in your portfolio is considered a smart move.
7. Failing to Check Liquidity
Liquidity refers to how quickly and easily you can sell your bond at a price you like if you need or want to.
Financial publications, market data/quote services, brokers and company websites may provide information about the liquidity of the issue you hold. More specifically, one of these sources may yield information about the daily volume of bond trades.
Generally speaking, the stocks and bonds of large, well-financed companies tend to be more liquid than those of smaller companies. The reason for this is simple—larger companies are perceived as having a greater ability to repay their debts.
However, other factors can affect any company’s bond liquidity, including periods of market volatility, interest rate volatility, credit upheavals, and any other reasons for heavy bond selling. The status of a dealer’s bond inventory may also impact liquidity.
If an issue is traded daily in large volumes, is quoted by brokerages, and has a fairly narrow spread, it is probably liquid.
Are Bonds Less Risky Than Stocks?
You often hear that bonds are less risky than stocks. Certain bonds, such as those issued by the U.S. government, are virtually free of any risk of default. Also, bonds offer a guaranteed return where stocks do not. And they’re usually less volatile than stocks. But stocks outperform bonds over time, and have more upside potential. Whether bonds are less risky for you in particular depends on the risks that concern you. Risks to bonds include changes in interest rates, inflation, potential default, and more.
Can I Lose Money by Buying Bonds?
Yes, you can. For example, if the company that issues your bond defaults on its payment obligation, you can lose the money you invested plus the promised interest payments. If interest rates rise, the price of your bond will drop and you’ll lose money if you have to sell your bond for less than your purchase price.
Why Buy Bonds?
Bonds offer income, capital preservation, and the potential for some capital appreciation. They can also serve as a hedge against losses due to equities. They offer useful benefits if you seek to diversify your portfolio.
The Bottom Line
Investors may not realize that, while bonds are considered more conservative than stocks, they come with risks. These include interest rate risk, inflation risk, default risk, and more.
Be sure that you understand all the risks involved in bond investing before buying debt securities. Proper research can help you to make the most of what bonds offer and to avoid the mistakes that could produce low or negative returns.
