The 4 Rules of Bond Investing

For any investor considering investing in bonds, there are some important things to know beforehand. We present the four key bond investing rules to follow:

1. Know what you are getting with bond funds.

Bond investors can invest in individual bonds or in bond funds, which hold a mix of bonds. Bond funds have the advantage of allowing the bond investor an easy way to diversify his or her bond holdings. In addition, bond funds are run by professional bond investors who closely monitor their bond portfolios.

However, a bond investor must be aware of the fundamental differences between bond funds and individual bonds when selecting one of these investment options. If a bond investor is keen to perform his or her own analysis and invest in the bonds of select companies, the bond investor will usually need to purchase individual bonds.

Another difference between bond funds and individual bonds is that individual bonds mature; that is, the principal is paid back at the end of the term of the bond. A bond fund does not mature, but when the bonds it holds matures, the bond fund reinvests in other bonds. This aspect of bond funds makes it more difficult, relative to owning individual bonds, for a bond investor to keep close watch on his or her bond portfolio.

2. Understand your risks.

Bonds are issued by an enormous variety of entities (governments, corporations, municipalities). The range of risks offered by bonds mirrors the diversity of their issuers. A successful bond investor has to understand the risks in his or her bond portfolio; failure to understand these risks can be catastrophic.

Risks of bond investment should not be understood narrowly to mean the risk of a price decline in the bond or the risk of default, but should include opportunity risk and inflation risk.

To fully understand the risks of their bond portfolios, bond investors should develop a circle of competence in bond investing, and stick to that area of proficiency. Bond investors who dabble in wildly different kinds of bonds with different risk profiles are flirting with disaster. Often, such a portfolio is a sign of reaching for yield.

3. Don’t reach for yield.

A bond investor reaches for yield when he or she no longer is satisfied with the bond yields available and moves outside of his or her circle of competence to invest in higher yielding bonds. This is very dangerous, and can end badly for the bond investor.

There is nothing wrong with investing in lower quality bonds that have a higher yield, but a bond investor who does this must understand high yield bonds. Problems arise when an investment grade bond investor moves into high yield bonds simply because the bond investor wants to get a greater return. In this situation, the bond investor has not ensured that he or she is getting paid the right amount to take the additional risks offered by the high yield bond.

While reaching for yield can produce higher returns for several years or several months, a bond investor who does not demand an appropriate premium for risk can eventually get burned. A bond investor must be willing to let money be idle rather than accepting too low of a risk premium.

4. Monitor your portfolio.

Bond investors must monitor their portfolios closely. If a bond has moved outside the investor’s circle of competence, the bond investor should be willing to sell the bond.

For instance, if a corporate bond owned by an investment-grade bond investor is downgraded to junk status, that bond investor must strongly consider selling the bond. Although the bond investor will undoubtedly take a loss on the bond, it is better than holding a bond whose investment qualities are not understood by the investor.

Likewise, if a high yield bond investor owns a bond of a company that defaults and files for bankruptcy, that bond investor should strongly consider selling that bond unless he or she understands distressed debt investing.

Bond investors should always demand an appropriate premium for the risk represented by a bond. This is not only true when purchasing bonds. If a bond moves out of an investor’s circle of competence, the investor can no longer be sure that he or she is being appropriately compensated for the risk of holding the bond.

Similarly, bond investors should be aware of possible bubbles in their area of the bond market, and be prepared to sell bonds when prices are too high and yields are too low for the investment risk.

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