Introduction
Bonds are fixed-income instruments that are considered relatively safer. Investors looking for a consistent source of income or capital preservation often contemplate incorporating bonds into their portfolios.
When an individual invests in bonds, they are providing a loan to a company or the government, and in return, they compensate the investor for extending them a loan. The return on investment from owning a bond includes the periodic interest payments and the return of the principal amount at the time of maturity date.
Having gained an understanding of bonds, let’s delve into the common mistakes to avoid while investing in bonds. Investing often entails making mistakes, but some of them can be averted through proper awareness and recognition.
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Lacking a Clear Plan
One common mistake that novice investors make is having a well-defined investment plan. Before investing, it is crucial to establish specific goals, determine your risk tolerance, and formulate a strategy that aligns with your financial objectives. Investing without clear goals and a clearly defined strategy can result in erratic decision-making.
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Neglecting Interest Rate Risk
Interest rate risk is a significant factor to consider while investing in bonds. Bond prices are inversely related to interest rates. Bond prices decline when rates increase and vice versa. Investors should not ignore the interest rate risks. Interest rates are influenced by factors such as money supply and demand, inflation, and government fiscal and monetary policies.
Bond prices decline if interest rates rise after you buy a bond. If you decide to sell your bond in the secondary market, it will be traded at a discount because the buyer will receive a smaller return. In the same way, the bond will be traded at a premium during a market downturn.
Hence, it is recommended that bondholders retain their bonds until maturity. Selling the bond before maturity carries the risk of potential losses if interest rates go in the wrong direction.
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Ignoring Credit Quality
One of the biggest mistakes investors make is neglecting the credit quality of the bonds they are investing in. It is crucial to conduct thorough research on bond ratings provided by rating firms. These ratings help you determine the underlying risk and avoid potential mistakes that could put your principal at risk.
These ratings are done by registered rating agencies like CRISIL, ICRA, CARE, India Ratings etc. that assess the issuer’s financials taking into account various metrics and factors, and also predict the probability and their ability to meet payment obligations. These agencies use a rating scale ranging from AAA (representing the lowest risk of default) to D (representing default) to determine the creditworthiness of the issuers. However, it is important to note that while credit ratings can be viewed as a useful filtering tool, they should not be considered as an absolute measure for investing in bonds.
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Failing to Diversify
Diversification is a fundamental principle of investing that helps spread risk across different assets and asset classes. However, some investors overlook diversification when it comes to bonds and concentrate their investments on a few issuers or sectors. This approach exposes investors to concentration risk, where adverse developments in a particular issuer or sector can have a significant impact on their bond portfolio. It’s a common misconception that diversification only involves investing in different asset classes. In reality, diversification should also be applied within the same asset class. To mitigate this risk, investors should diversify their bond holdings across different issuers, sectors, and maturities.
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Overlooking Inflation
Inflation is a measure of the pace at which the overall prices of goods and services increase, chipping away at a currency’s purchasing power. Investors must pay attention to the inflation statistics as it can severely impact the returns on the bond.
Inflation influences the future purchasing power of a bondholder, especially for bondholders whose yield is less than the inflation rate. It is recommended to invest in bonds whose post tax returns beat the prevailing inflation rate in the market. However, this does not mean individuals should not invest in bonds with low yields issued by reputable corporations. This is just to remind you that you can protect your investments from inflation by investing in other high-yielding bonds that pay higher yields, thereby safeguarding your purchasing power.
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Neglecting the Status of the Bond
Another common mistake by investors is neglecting the status of the bond. Bonds have distinct positions in the hierarchy of the debt obligations of the issuing entity. Bonds can be classified into various categories like senior secured, senior unsecured, subordinated, or junior, based on their priority in repayment in the event of bankruptcy or default.
A senior secured bond is typically backed by collateral such as receivables or asset or any equipment. They are given priority in claiming assets in case of bankruptcy and liquidation. In the case of bankruptcy, bond investors are granted the foremost entitlement to a company’s assets. In other words, they theoretically have a higher likelihood of recovering their investment if the company goes out of business.
It is crucial to understand the nature of the debt you possess, to determine the level of risk undertaken. To determine a bond’s seniority level, investors can check the company’s prospectus for the same.
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Lack of Proper Research
Many investors make the mistake of making investments quickly without conducting thorough research which can result in poor results. It is crucial to meticulously assess the fundamental aspects of an investment, understand the underlying assets, including its financial stability, and management team, and keep abreast of market trends. Conducting proper research is important for making well-informed decisions as insufficient knowledge can result in financial losses.
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Not checking for Liquidity
Investors should assess the liquidity of the issue which can be found in various financial publications, market data services, through brokers, or on the company’s website. You can get information about the volumes of trades done by the bond daily from one of these sources.
This information is crucial for bondholders if they want to sell their positions because enough liquidity will ensure that there will be buyers in the market who are willing to take it over. Generally, the bonds of large, well-funded companies are easier to buy and sell than those of smaller companies because larger companies are perceived as having a greater ability to repay their debts.
While there is no recommended level of liquidity, it is advisable to consult a financial advisor or conduct research before making an efficient decision.
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Timing the Market
Trying to time the market can be a potentially huge mistake. Even the most seasoned investors find it challenging to forecast market movements correctly. Instead, it will be wise to choose a long-term investment strategy and focus on consistently investing over time. The fluctuations in the market generally tend to balance out over the years; so it is advisable to stay clear of buying and selling driven by short-term fluctuations.
Conclusion
Summing up, bonds are generally considered low-risk assets and more conservative than stocks. However, numerous investors commit mistakes while choosing bond investment due to a lack of awareness and research of the bond market. Investors who neglect this groundwork face the potential of experiencing minor to negative returns.
Disclaimer: Investments in debt securities/ municipal debt securities/securitized debt instruments are subject to risks including delay and/ or default in payment. Read all the offer-related documents carefully.
FAQs
Q1. What are some of the most common investment mistakes that investors make?
Ans. Some of the most common investment mistakes that investors make while investing in bonds are not having clear goals, not diversifying one’s portfolio, overlooking inflation, and not checking the issuer’s background, to name a few.
Q2. What are the consequences of failing to diversify your investment portfolio?
Ans. Failing to diversify your investment portfolio may lead to overexposure to a particular asset or market, increasing the risk of significant losses in the event of poor performance in that asset or market.
Q3. What is the safest way to invest in bonds?
Ans. Government bonds in India, categorized as government securities (G-Sec), mainly serve as long-term investment instruments for periods extending up to 40 years. These bonds are government-backed hence they carry a negligible risk of default which is why they are also known as risk-free gilt-edged securities.
Q4. What is the biggest risk of bonds?
The biggest risk of bonds is that the issuer might not meet its obligations of not paying interest and returning the principal upon maturity.
