How To Avoid The Pitfalls Of Bond Investment

How To Avoid The Pitfalls Of Bond Investment

How To Avoid The Pitfalls Of Bond Investment - Risk of Investing In Foreign BondsThere is a balance between risk and return in all investments. Risk is the chance of losing a portion of the invested money and return is the money gained from investment. Generally, for generating higher return an investor should take greater risks. Less risky investments provide lower return.

Investing in bond has been hailed as low risk option to preserve capital and earn regular income. However, an investor should be aware of the pitfalls of bond investment before going ahead with investment plans.

Bond vs. stock

Bonds are considered less risky than stocks for different reasons. They carry a promise of the issuer to return the face value of the security on date of maturity. There is no such promise for the stock holder. Most bond holders receive a fixed income at a declared rate and regular interval from the issuer. While stocks sometimes pay dividends, there is no such promise from the stock issuing company to pay regular dividends. Bond market is much more stable than stock market. Historically, return from stocks has been much higher than return from bonds.

Learning about yields

Return from a bond investment is known as yield. Current yield of bond is function of coupon rate and current price of the bond. Coupon rate is the annual rate of interest that the issuer promises to pay to the investor. It is stated as percentage of bond’s face value (par). Current price may be more than (at a premium) or less than (at a discount) par value.

Yield-to-maturity of a bond at a particular time reflects the relation between the interest payments remaining from that period to maturity and difference between current market price and par value. Yield-to-call at a particular time represents the interest payments remaining from that period to first call date and difference between current market price and call price of the bond.

When risk of investing in a bond is high, investors are compensated with high yields for taking the risk. As such, higher yield is associated with higher risk. Bonds that are issued for short term have lower yields than long term bonds with maturity period of 10 or more years. Long term bonds are more susceptible to conditions like inflation and substantial change in rate of interest. While all bonds suffer for rising interest rate, bonds with lower coupon rate are worst hit

Losses from trading

There are many investors who prefer to trade bonds. Rate of interest and price of bond have an inverse relation. Fall in rate of interest triggers price rise of bonds. Similarly, bond prices falls as rate of interest climbs up. Investors look for opportunities to buy bond at lower price from market and sell them at higher price. Such trading practice is not desirable with bonds. In case an investor fails to read the trend of interest rate there may be substantial losses in bond trading.

Price of a bond may take serious hit when the issuing entity is faced with grave problems. When the credit agencies downgrade the credit worthiness of borrower and price of the bond may fall. Such fall in price may also happen when the issuing entity is undergoing major restructuring at corporate level. These changes may leave bondholders with steep loss. Investors are required to keep close eye on reason of restructuring, financial situation of the issuing entity along with the prospect of changing situation. Expert help from sought when the investment is substantially high.

When the trading of bond is widely spread there may be issues related to liquidity. Over the counter bond trading may result in lack of visibility. There may be lack of crucial information on bid/ask spread.

Inflationary losses

Inflation is the silent killer. When you are happy with the return of 6% per year from your bonds the inflation may be running at 7%. This means you are losing money on your investment what’s worse, you don’t even realize it! Inflation also leads to high interest rate consequently lowering price of the bond.

Risks of foreign bonds

Investing in international bonds or foreign bonds is attractive for many investors seeking higher than average return from fixed income securities. Higher than average coupon rate and diversifying risk are main objectives. However, investors should be aware of some inherent risks while investing in international bonds.

Fluctuation of exchange rate between country of the investor and foreign bond issuing nation may be a major concern. This may lead to fall in bond price. Interest rate scenario in the issuing country may spoil the return expected from the bond. There are instances when a foreign bond issuing nation imposes exchange controls and no money can leave the country. In such cases invested money gets trapped until such embargo is lifted. Taxation on foreign bonds may leave the investor with smaller gains and the inflationary condition of the issuing country may worsen the real return.

Risks of municipal bonds

There are several ways to lose your money in municipal bonds. “Munis” are primarily valued for tax exemption. When there is a significant decrease in federal and local tax rates, value of munis drop substantially. So long as the taxation rates are high there is a demand for munis.

Specific legal requirements should be met for maintaining the tax exempt status. Change in legal perspectives may change the status of the issuers of munis. In such conditions, price of a municipal bond may be adjusted against similar issues. In many cases this may lead to fall in price. Credit rating of the issuer may get downgraded for significant losses in investment or irresponsible spending.

Call risk

It is important to verify about the “call provision” of a bond. Some bonds have this provision that entitles the issuers to “call back” or redeem the bond at a date prior to maturity. Declining interest rate may instigate an issuer to call back the bond issued at higher interest and raise fresh capital at lower rate of interest. In such case the investors are forced to reinvest their capital at lower rate of interest. Investors who have paid a premium for buying bond stand to lose their capital on event of such call back.

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