You’re ready to add bonds to your investment portfolio because it provides income, and/or as a means to preserve capital. Sound like you? If so, avoid these four common mistakes:
1. Inflation matters
Don’t ignore the impact of inflation, which in simple terms is the rising price level for goods and services.
You may be tempted to gloss over the little fact that inflation has the power to whittle away your investment. But, you won’t be happy when your bond matures and find that the money returned to you buys you less than it did when you first purchased the bond.
Consider the difference between the nominal (return of the bond) and the real (accounting for inflation) return of your bond.
To remember the difference, don your today hat and your future hat when you buy bonds. If your nominal bond return today is 2% and the rate of inflation projected is at 3%, the difference between the two, or the real return, is -1%.
When you hear news of impending inflation, find a way to reduce its impact on your portfolio.
To keep pace with inflation, add other investments that give you a chance of a higher return.
2. Research is key
If you quake at the thought of investing in bonds, the good news is that research mitigates much of the complexity. Once you get a handle on the terminology, the research and analysis you engage in will reap benefits.
Research will acquaint you with the fundamentals of any issuer and ensure the bond you are investing in will be repaid at its maturity. It’s easy to check a company’s history of reporting consistent earnings by reviewing past annual reports and past performance.
Examining a company's management discussion and analysis (MD&A) section and proxy statement are also useful to shed light on its ability or inability to make payments.
You may also learn about future risks that could have a negative effect on a company's ability to meet its debt obligations.
Bond ratings [see corporate bonds] issued by rating agencies are another important research tool. They can help you to ascertain how much risk you are comfortable with and to avoid any blunders that may risk your principal.
Rating agencies do the legwork in reviewing the company financials of the issuer and make a judgment call on their ability to pay compared with other bond issuers.
The rating scale ranges from AAA for top quality followed by AA, A, BBB, BB, B, CCC, CC, C and D, with other subdivisions unique to each rating agency.
The higher the rating, the safer the bond but typically the lower the interest rates. The lower the rating, the higher the interest rate paid. High-yield (also called junk) bonds are rated at BB+ or below [see junk bonds].
3. Depth and breadth of the bond market
Variety is the spice of life with bonds. Understanding which type of bond(s) meet your needs will be your priority.
Weigh the factors – length of time of your investment, level of risk, type of return and tax treatment – against the many different types of bond [see intro to bond] available.
Understand the primary entities that are seeking to raise capital:
- Local authorities through the UK Municipal Bonds Agency
Each will offer different types of bonds with maturities of varying lengths (10 years or more), while notes fall in the two-year to 10-year range and bills are shorter term.
Corporates will offer bonds secured against general or specific type of assets and unsecured, which are not backed by specific assets.
There are also convertibles, which can be swapped for shares in the company at a set price at or before a specified date.
4. Safer but still with risk
Investing in bonds is useful for adding stability and a bit of diversification to a portfolio but these are not without risk.
An issuer with a high pedigree does not guarantee a bond will be redeemed. Many high-profile failed businesses serve as examples here in the UK: BHS; Woolworths; Borders bookstore; electrical retail chain Comet Group.
In short, don’t assume a household name is automatically sound; remember to research whether the issuer can meet its obligations.
All bonds are subject to other risks, which fall into three categories:
(see intro to bond; corporate bond story)
- Credit/default risk
- Interest rate risk
- Liquidity risk
- Inflation/purchasing power risk
- Call risk
- Event risk