Individual investors seeking income or the preservation of capital often consider adding bonds to their portfolios. Unfortunately, most investors don't realize the potential risks that go along with an investment in a debt instrument.
In this article, we'll take a look at seven of the more common mistakes made and the issues overlooked by fixed-income investors.
Debt Instruments Basics
Debt instruments include fixed and variable bonds, debentures, notes, certificate of deposit, and bills. These products are used by governments and companies to raise funds to finance activities and projects. Debt securities can take many forms. Some can offer a high rate of return but the holder must also assume elevated risks.
Those who issue bonds are known as issuers and the investor who buys the bond is the bondholder. Bondholders act as a lender and will receive an interest payment for loaning money. The seller of the security promises to repay the lender at a future—maturity—date.
Other important features of debt securities include:
- Coupon rate: the rate of interest to be paid on the bond.
- Maturity date: the date at which the security will be redeemed.
- Call provisions: the outline of options the company may have to buy back the debt at a later date.
- Call information: this is particularly important to know because of the numerous pitfalls that can be associated with this feature. For example, suppose interest rates decline sharply after you purchase the bond. The good news is that the price of your holding will increase; the bad news is that the company that issued the debt may now be able to go into the market, float another bond and raise money at a lower interest rate and then use the proceeds to buy back or call your bond. Typically, the company will offer you a small premium to sell the note back to them before maturity. But where does that leave you? After your bond is called, you may owe a big tax liability on your gains, and you will probably be forced to reinvest the money you received at the prevailing market rate, which may have declined since your initial investment.
(See also, Why Companies Issue Bonds)
1. Ignoring Interest Rate Moves
Interest rates and bond prices have an inverse relationship. As rates go up, bond prices decline, and vice versa. This means that in the period before a bond's redemption on its maturity date, the price of the issue will vary widely as interest rates fluctuate. Many investors don't realize this.
Is there a way to protect against such price volatility?
The answer is no. The volatility is inevitable. For this reason, fixed-income investors, regardless of the length of the maturity of the bonds they hold, should be prepared to maintain their positions until the actual date of redemption. If you have to sell the bond before maturity, you may end up doing so at a loss if the interest rate has moved against you.
(For more insight, see What Are the Risks of Investing in a Bond?)
2. Not Noting the Claim Status
Not all bonds are created equal. There are senior notes, which are often backed by collateral (such as equipment) that are given the first claim to company asset in case of bankruptcy and liquidation. There are also subordinated debentures, which still rank ahead of common stock in terms of claim preference, but below that of the senior debt holder. It is important to understand which type of debt you own, especially if the issue you are buying is in any way speculative.
In the event of bankruptcy, bond investors have the first claim to a company's assets. In other words, at least theoretically, they have a better chance of being made whole if the underlying company goes out of business.
To determine what type of bond you own, check the certificate if possible. It will likely say the words "senior note," or indicate the bond's status in some other fashion on the document. Alternatively, the broker that sold you the note should be able to provide that information. If the bond is an initial issue the investor can look at the underlying company's financial documents, such as the 10-K or the prospectus.
3. Assuming a Company Is Sound
Just because you own a bond or because it is highly regarded in the investment community doesn't guarantee that you will earn a dividend payment, or that you will ever see the bond redeemed. In many ways, investors seem to take this process for granted.
But rather than make the assumption that the investment is sound, the investor should review the company's financials and look for any reason it won't be able to service its obligation.
They should look closely at 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. Ideally, there should be at least two times coverage in order to feel comfortable that the company will have the ability to pay down its debt.
(To learn how to read and break down financial statements, see What You Need To Know About Financial Statements.)
4. Misjudging Market Perception
As mentioned above, bond prices can and do fluctuate. One of the biggest sources of volatility is the market's perception of the issue and the issuer. If other investors don't like the 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 will decrease in value. 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, it will likely spill over and be reflected in the price of the bond as well.
5. Failing to Check the History
It is important for an investor to look over old annual reports and review a company's past performance to determine whether it has a history of reporting consistent earnings. Verify that the company has made all interest, tax, and pension plan obligation payments in the past.
Specifically, a potential investor should read the company's management discussion and analysis (MD&A) section for this information. Also, read the proxy statement—it, too, will yield clues about any problems or a company's past inability to make payments. It may also indicate future risks that could have an adverse impact on a company's ability to meet its obligations or service its debt.
The goal of this homework is to gain some level of comfort that the bond you are holding isn't some type of experiment. In other words, check that the company has paid its debts in the past and, based upon its past and expected future earnings is likely to do so in the future.
6. Ignoring Inflation Trends
When bond investors hear reports of inflation trends, they need to pay attention. Inflation can eat away a fixed income investor's future purchasing power quite easily.
For example, if inflation is growing at an annual rate of four percent, this means that each year it will take a four percent greater return to maintain the same purchasing power. This is important, particularly for investors that buy bonds at or below the rate of inflation, because they are actually guaranteeing they'll lose money when they purchase the security.
Of course, this is not to say that an investor shouldn't buy a low-yielding bond from a highly-rated corporation. But investors should understand that in order to defend against inflation, they must obtain a higher rate of return from other investments in their portfolio such as common stocks or high-yielding bonds.
(To continue reading about inflation, see The Importance of Inflation and GDP.)
7. Failing to Check Liquidity
Financial publications, market data/quote services, brokers and a company's website may provide information about the liquidity of the issue you hold. More specifically, one of these sources may yield information about what type of volume the bond trades on a daily basis.
This is important because bondholders need to know that if they want to dispose of their position, adequate liquidity will ensure that there will be buyers in the market ready to assume it. 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.
Is there a certain level of liquidity that is recommended? No. But if the issue is traded daily in large volumes, is being quoted by the large brokerage houses and has a fairly narrow spread, it is probably suitable.
The Bottom Line
Contrary to popular belief, fixed income investing involves a great deal of research and analysis. Those who don't do their homework run the risk of suffering low or negative returns.