7 common bond buying mistakes

Individual investors looking for income or capital preservation usually consider adding bonds to their portfolio. Unfortunately, most investors do not realize the potential risks of investing in debt instruments.

In this article, we will look at seven common mistakes and overlooked issues that fixed income investors often make.

Key points

  • Bonds and other fixed income investments are often described as more conservative and less risky than stocks.
  • Nevertheless, investors may make costly mistakes when trading in the bond market, which is easy to avoid.
  • Here, we reviewed 7 common pitfalls, from ignoring interest rate changes to failing to conduct due diligence on bond issuers.

Bond basis

Debt instruments include fixed and variable bonds, bonds, bills, certificates of deposit and bills. Governments and companies use these products to raise funds to fund activities and projects. Debt securities can take many forms. Some can provide a high rate of return, but the holder must also take a higher risk.

The person who issues the bond is called the issuer, and the investor who buys the bond is called the bondholder. The bondholder acts as a lender and will receive interest on the loan. The seller of the security promises to repay the lender on the future maturity date.

Other important characteristics of debt securities include:

  • Coupon interest rate: The interest rate of the bond.
  • Maturity Date: The date when the security will be redeemed.
  • Redemption clause: A summary of options for which the company may have to repurchase debt in the future.
  • Call information: It is especially important to understand this, because this feature may have many flaws. For example, suppose that interest rates drop sharply after you buy a bond. The good news is that the price you hold will rise; the bad news is that the company that issued the bond may now be able to enter the market, issue another bond and raise funds at a lower interest rate, and then use the proceeds to buy back or redeem you Of bonds. Usually, the company will offer you a small premium to sell the notes back to them before maturity. But where will this get you? After your bond is redeemed, you may be heavily taxed on your income, and you may be forced to reinvest the funds you received at the prevailing market interest rate, which may have been since your initial investment Has fallen.

1. Ignore interest rate changes

Interest rates are inversely proportional to bond prices. As interest rates rise, bond prices fall, and vice versa. This means that within a period of time before the bond is redeemed on the maturity date, the issue price will vary greatly with the fluctuation of interest rates. Many investors do not realize this.

Is there a way to prevent such price fluctuations?

The answer is no. Volatility is inevitable. For this reason, fixed-income investors, regardless of the length of their bond maturity, should be prepared to maintain their positions until the actual redemption date. If you must sell the bond before maturity, you may end up losing money if the interest rate is not good for you.

(For more insights, see What are the risks of investing in bonds?)

2. Not paying attention to claim status

Not all bonds are created equal. There are senior notes, which are usually backed by collateral (such as equipment), and in the case of bankruptcy and liquidation, they first demand the company’s assets. There are also subordinated debentures, which are still ahead of common stock in terms of priority of debt, but lower than senior debt holders. It is important to know what type of debt you have, especially if the bonds you buy are of any speculative nature.

In the case of bankruptcy, bond investors have the first right to claim against the company’s assets. In other words, at least in theory, if the underlying company goes bankrupt, they have a better chance of getting back to their original state.

To determine which type of bond you have, check the certificate whenever possible. It may say “senior notes” or indicate the status of the bond in other ways on the document. Or, the broker who sold you the notes should be able to provide this information. If the bond is issued for the first time, investors can check the financial documents of the relevant company, such as the 10-K or prospectus.

3. Assuming a company is sound

Just because you own the bond or because it is highly regarded in the investment community does not guarantee that you will receive dividend payments or that you will always see the bond being redeemed. In many ways, investors seem to take this process for granted.

However, instead of assuming that the investment is reasonable, investors should review the company’s financial situation and look for any reasons for not fulfilling its obligations.

They should look carefully at the income statement and then calculate the annual net income figure and add taxes, depreciation and any other non-cash expenses. This will help you determine how many times this number exceeds the number of annual debt payments. Ideally, there should be at least twice the insurance so that the company can afford to repay its debts.

(To learn how to read and decompose financial statements, see What you need to know about financial statements.)

4. Misjudge market perception

As mentioned above, bond prices can and do fluctuate. One of the biggest sources of volatility is the market’s perception of issuers and issuers. If other investors do not like this offering or believe that the company will not be able to fulfill its obligations, or the issuer’s reputation is hit, bond prices will fall. If Wall Street is bullish on issuers or problems, the opposite is true.

A good piece of advice for bond investors is to look at the issuer’s common stock and see how people perceive it. If it is unpopular, or there is unfavorable research on stocks in the public domain, it is likely to overflow and be reflected in bond prices.

5. Unable to view history

For investors, it is important to review the old annual report and review the company’s past performance to determine if it has a history of reporting consistent earnings. Verify that the company has paid all interest, taxes, and pension plan obligations in the past.

Specifically, potential investors should read the company’s Management Discussion and Analysis (MD&A) section to obtain this information. In addition, please read the power of attorney-it will also provide clues about any issues or the company’s inability to make payments in the past. It may also indicate future risks that may adversely affect the company’s ability to fulfill its obligations or repay debt.

The goal of this homework is to get a certain degree of comfort, and the bond you hold is not some kind of experiment. In other words, check whether the company has repaid debts in the past, and based on its past and expected future earnings, may do so in the future.

(To learn more about management, see Assess the management of the company and Strengthen management.)

6. Ignore inflation trends

When bond investors hear reports about inflation trends, they need to pay attention. Inflation can easily erode the future purchasing power of fixed-income investors.

For example, if the inflation rate is increasing at a rate of 4% per year, this means that a 4% increase in returns is needed every year to maintain the same purchasing power. This is important, especially for investors who buy bonds at or below the inflation rate, because they actually guarantee that they will lose money when buying securities.

Of course, this is not to say that investors should not buy low-yield bonds from highly rated companies. But investors should understand that in order to resist inflation, they must obtain higher rates of return from other investments in their portfolios, such as common stocks or high-yield bonds.

(To continue reading about inflation, see The importance of inflation and GDP.)

7. Liquidity not checked

Financial publications, market data/quotation services, brokers and company websites may provide information about the liquidity of the circulation you hold. More specifically, one of these sources may produce information about the type of daily bond volume.

This is important because bondholders need to know that if they want to sell their positions, sufficient liquidity will ensure that there will be buyers in the market ready to take on it. Generally speaking, the stocks and bonds of large companies with strong capital tend to be more liquid than small companies. The reason is simple-larger companies are considered more capable of repaying debts.

Is there a recommended level of liquidity? Can not. However, if the stock has a large daily trading volume and is quoted by a large brokerage, the spread is quite narrow, it may be appropriate.

Bottom line

Generally speaking, bonds are less risky and more conservative than stocks. However, contrary to popular belief, fixed income investment involves a lot of research and analysis. Those who do not do their homework run the risk of suffering low or negative returns.

.

READ ALSO:   Bull market bond
Share your love