Mistakes To Avoid When Investing In Bonds
While there are multiple advantages to investing in bonds, investors often make mistakes that can prove expensive later. This article will discuss mistakes to avoid while investing in bonds.
Mistakes To Avoid While Investing In Bonds
Here is a list of common investment mistakes to avoid when investing in bonds in 2024.
1. Not Having A Clear Investment Plan
This is one of the most common mistakes investors make. An investment plan helps you align your bond investments with your overall financial goals and risk appetite. It also helps you avoid concentration of investment or over-diversification.
You can make an investment plan by following the below steps:
- Understand your income inflows vs outflows
- Differentiate between short, medium, and long-term goals
- Evaluate the risk-reward you are comfortable with
- Understand different investment instruments and decide on an asset allocation
- Build and monitor your portfolio
- Regularly review and rebalance your portfolio
Based on these factors, you need to decide your exposure to investing in bonds.
2. Neglecting Interest Rate Risk
Interest rate risk refers to the risk of fluctuations in bond returns based on central bank interest rate changes, i.e., the repo rate. Usually, repo rate and bond prices have an inverse relationship; if the repo rate increases, bond prices reduce. This is because an increase in repo rates reduces bond prices in the short term. Investors prefer long-term bonds to earn a better return because, in the long run, the repo rate can be reduced, increasing bond prices.
For example, you purchased a 9% 5-year bond when the repo rate was 3%. The return is fixed and higher than the repo rate, which makes it attractive to invest. However, if the central bank increases the repo rate to 3.5% due to increased inflation, the earlier bond investment will give a lower return, and its price in the market will decline. This is because more investors would look for a bond with a higher return.
3. Ignoring Credit Quality
Bonds' credit quality is directly related to their creditworthiness. Credit ratings range from D, the lowest rating with a high chance of defaulting, to AAA, the highest rating offering the most safety of invested capital.
There are five credit rating agencies in India: Credit Analysis and Research (CARE), Credit Rating Information Services of India Limited (CRISIL), India Ratings and Research Pvt. Ltd., Investment Information and Credit Rating Agency of India Limited (ICRA), and Acuite Ratings and Research Ltd.
Investors should only invest in investment-grade bonds (with a rating of BBB or more) to minimise default risk.
Read more about Investment-grade bonds.
4. Missing Portfolio Diversification
When investing in bonds, diversification can be seen in two ways. The first type refers to investing in bonds to diversify the investment portfolio. For instance, invest in bonds to add stability if your portfolio is equity-heavy. The second type refers to investing in different bonds to avoid concentration.
For example, park your funds in corporate bonds from different sectors or combine corporate and government bonds to diversify your portfolio.
Read more about 7 Best Corporate Bonds To Buy In 2024
5. Overlooking Inflation
Inflation is like a hidden tax you pay on your investments. With rising inflation, everything becomes expensive, and investments are no exception. Bonds lose their value with an increase in the inflation rate.
For example, if the bond yield is 9% and the inflation rate is 4%, your actual return on investment is only 5%. As the inflation increases, the real return decreases. To combat inflation, you should invest in bonds having different yields and maturities. Long-duration bonds are also helpful here as they offer higher yields and can shield you against rising inflation.
6. Ignoring The Bond Status
There are different categories of bonds, as below.
- Guaranteed Bonds: They are guaranteed by third-party
- Senior Secured Bonds: Highly safe bonds that have collateral securities
- Junior Secured Bonds: They fall between senior secured and senior unsecured boards and have collateral securities
- Senior Unsecured Bonds: They do not have any collateral securities and thus are considered high-risk
- Junior Or Subordinated Bonds: They are given the last preference in case of default. Due to the high risk involved, they yield high returns
You should invest in bonds, considering their credit status and whether they align with your goals and risk appetite. Guaranteed or senior secured bonds are suitable investment options if you want secure investment options.
7. Lack Of Proper Research
For investing in bonds, it is important that you research different factors such as:
- Type of bonds and bond yield offered
- Credit rating
- Collateralised assets
- Track record of the entity issuing bond
- Bond management team
You should compare these details with available bonds to make an informed decision.
8. Liquidity Of Bonds
Liquidity refers to how easily you can sell your bonds and get the invested capital back. Often, investors commit the mistake of not checking the liquidity of bonds. Bonds usually have a fixed tenure ranging from a few months to years.
Based on your financial needs, choose the maturity of bonds and check for penalties in case of early withdrawal.
Conclusion
Bonds are fixed-income investment tools that help diversify your portfolio and add stability through returns. However, avoid these common mistakes when investing in bonds to make the most of your financial journey and build wealth over time.
To stay updated with the latest financial concepts, explore Grip Invest.
Frequently Asked Questions On Mistakes To Avoid When Investing In Bonds
1. Who should invest in bonds?
Bonds are suitable investment options for individuals looking to diversify their portfolios and invest in low-risk, fixed-return tools. They are a good alternative to keeping all your money in fixed deposits, as bonds offer up to 100% more returns within similar tenures.
2. Can you lose money on bonds if held to maturity?
Bonds carry certain risks, such as credit risks. If the bond defaults on payment, you can lose the returns you were likely to receive. Sometimes, a default can also lead to losing the initial capital investment. You should always check the credit rating of bonds to avoid this situation.
3. What is the major advantage of investing in bonds?
Bonds offer two major advantages:
- They have comparatively lower risk than equity and offer comparatively better returns than other debt instruments like fixed deposits.
- They offer predictable periodical returns, providing a fixed-income source.
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