Though the stock market is rallying, bond buying also remains healthy. “Some $2.1 billion rolled into U.S. investment-grade corporate-bond mutual and exchange-traded funds in the week ending Feb. 8, the third most since 2010,” reports The Wall Street Journal. Though spreads are narrow, the buying boom continues as future opportunities look scant. For those looking to diversify their portfolio with bonds, there are a few critical mistakes to avoid. Let’s look at the key five.
1. Avoid short-term thinking.
A long-term game plan is critical for bond investors. To capitalize on the full value of a bond, you must hold it until maturity. The reason for this strategy is simple. Bond yields and prices have an inverse relationship. Bond prices fall as interest rates rise. Therefore, if interest rates increase after you buy a bond, then its value may drop. The best way to avoid a loss like this is to hold the issue until it reaches maturity.
2. Avoid hasty purchases.
Bonds are considered a less risky investment than stocks. While it’s true that the volatility of bonds is less than stocks, there are risks to consider. When you buy a bond, you’re extending a loan. You want to ensure that the borrower, the company issuing the bond, has a strong history of repayments. Bonds have less volatility than stocks. However, you can still lose your investment. Check the rating of the bond to become comfortable with the underlying company.
3. Avoid illiquidity.
Liquidity risk is the danger that an asset cannot be sold at, or near its value. In short, you want to know there will be a market ready to buy your bond when you sell. This concept ties into the above paragraph. If the company issuing the bond has a solid credit rating and a good history of debt management, then you likely won’t have a problem selling the bond. However, smaller companies seeking to attract investors with high yields may falter in the future. In such a case you might be stuck with an illiquid holding that you cannot sell.
4. Avoid risk.
Risk, even with bonds, cannot be eliminated entirely. However, diversification goes a long way towards mitigating the loss of capital. Bonds come in all shapes and sizes. Municipal bonds, for example, offer excellent tax benefits. High-yield bonds (“junk bonds”) provide high yields at high risk. Zero-coupon bonds make no coupon payments but come at a discounted par value. Do your homework to ensure that you aren’t too centralized in just one style of bonds. Moreover, ensure that you hold bonds issued by a variety of companies from different sectors.
5. Avoid tax pitfalls.
Investors rarely account for the tax implications of their decisions. For example, an investor may choose a municipal bond for its tax-friendly characteristics. However, this choice comes at a cost. A municipal bond is likely to pay a lower yield relative to a corporate bond. Consider the tax bracket you’re in and do the math to determine the after-tax income. The ultimate value of a municipal bond may be less than that of a corporate issue.
Bonds are sophisticated instruments that serve to do more than simply offset equity risk. They can be reliable sources of income if researched properly. However, long-term conditions will impact these steady cash flows. For this reason, also consider the future burden of inflation and how it may erode the purchasing power of your earned coupon payments.
For more check out 15 Money Mistakes You Shouldn’t Make!