Bonds are often seen as the “boring” part of an investment portfolio. Many investors buy them simply because they want to diversify, assuming that fixed-income investments are relatively safe and straightforward. But there is more to bonds than simply looking at the interest rate and investing.
A bond offering a higher return could carry higher risk, while buying several bonds does not necessarily mean you have a well-diversified portfolio. And if you suddenly need the money before maturity, selling the bond may not always be easy.
As more retail investors explore bonds, experts say looking beyond the headline yield is important. Here are five common mistakes investors should avoid when building a bond portfolio.
A higher return can be attractive, but investors should first understand why a bond is offering that yield. In many cases, a higher yield comes with higher credit or business risk.
“Higher yield should always be questioned — why is the issuer offering a higher return?” said Nishchay Nath, Founder and CEO, BondScanner.
A high yield could point to a weaker balance sheet, lower credit rating, higher business risk or limited liquidity. Investors should therefore look at the company’s debt levels, interest coverage ratio, operating cash flows, industry outlook and repayment track record.
Paresh N. Bhagat, MD and Chairperson of Mangal Keshav Financial Services, said investors should focus on risk-adjusted returns rather than maximum returns.
Buying multiple bonds may give investors a false sense of diversification. If most of those bonds are issued by the same company, business group or sector, the portfolio could still be heavily exposed to one source of risk.
“Diversification is critical in fixed-income investing,” Nath said.
Investors should spread their bond investments across issuers, sectors, credit profiles and maturities. This can help ensure that problems with one investment do not have a major impact on the overall portfolio.
A credit rating is an important starting point, but it should not be the only thing investors check before buying a bond.
Bhagat said investors should look at the issuer’s financial strength, repayment history and credit rating. They should also examine the company’s profitability, leverage and ability to generate cash.
The structure of the bond also matters. Investors should know whether it is secured or unsecured and understand the level of protection it offers.
A bond may offer an attractive return, but that does not make it suitable for every investor. One of the key questions is when the money will be needed.
Longer-duration bonds are more sensitive to changes in interest rates. Investors should therefore match the maturity of their bonds with their financial goals and expected cash-flow needs.
“Longer-duration bonds are more sensitive to interest-rate movements,” Bhagat said.
If an investor may need the money before maturity, there is another factor to consider — liquidity.
Investors often focus on how much interest a bond will pay and overlook whether they will actually be able to sell it easily.
Not every bond has an active market. If an investor wants to exit before maturity, finding a buyer at a fair price may not always be easy.
Nath said investors should avoid “overlooking liquidity, assuming every bond can be easily sold before maturity”.
This is particularly important for investors who may need access to their money unexpectedly.
Are bonds really ‘safe’?
One of the biggest misconceptions is that bonds are risk-free because they offer fixed returns. While bonds can provide relatively predictable cash flows, they still carry risks.
There is credit risk, where an issuer may struggle to repay interest or principal. There is interest-rate risk, as bond prices can fall when market interest rates rise. There is also liquidity risk, which can make it difficult to sell a bond before maturity at a fair value.
“A fixed return does not mean a guaranteed return,” Bhagat said.
What should first-time bond investors check?
Before putting money into a bond, investors should understand the issuer’s business and financial health. They should check the credit rating and the reasons behind it, compare the yield with the risk involved and understand the bond’s maturity and liquidity.
They should also look at the issuer’s leverage, cash flows and ability to repay its debt. Most importantly, investors should avoid putting too much money into one issuer or sector.
“Bonds can provide stability to a portfolio, but investors should approach them with the same discipline as equity investing — by understanding the underlying risk rather than simply chasing higher yields,” Bhagat said.