Traditional bonds are income investments. The issuer promises to make regular payments to bondholders and to return the face value of the bond, or the investor’s principal, at a designated maturity date. As you’ll eventually get your money back when you invest in bonds, they are generally considered safer investments than stocks, which offer no such guarantee of principal. However, there are still a number of risks attached to investing in bonds, and it’s essential that investors fully understand all of them before putting their money down. Here are some common mistakes that you should avoid when investing in bonds.
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Failing To Understand Interest Rate Risk
Just because a bond issuer guarantees the return of the face value of a bond at maturity doesn’t mean that its price always remains stable. In fact, bond prices can actually move quite a bit, particularly those with longer maturities. This is due to the inverse relationship between market interest rates and bond prices. In short, when interest rates rise, bond prices fall, and vice versa.
This principle is easy to understand if you look at a specific example. Imagine that you own a bond with a 10-year maturity and a 5% coupon rate. If market rates rise and new 10-year bonds that pay a 6% coupon are available, the price for your bond will fall because no investor would rather buy a 5% bond instead of a 6% bond, all other things being equal.
It’s important to note that interest rate risk is only a factor if you plan on selling your bond before it matures. For example, if you want to sell that bond after only five years, it’s possible that you will take a capital loss.
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Assuming All Bonds Are Guaranteed
All bonds have an implicit guarantee that you will receive the face value of the bond back at maturity, but that guarantee is only worth as much as the financial status of the issuer. With U.S. Treasury securities, for example, that guarantee is as good as gold, as it’s backed by the full faith and credit of the U.S. Treasury. However, if a corporate issuer with a low credit rating falls into bankruptcy or other financial distress, you may only get a portion of your money back, or none at all. This is known as credit risk.
Not Knowing How Bonds Are Taxed
When it comes to investing, what matters is what you keep, not what you earn. Corporate bonds, for example, are fully taxable, meaning the 5% coupon you earn might end up only being 4% or less in your pocket. Municipal bonds are generally tax-free at the federal level and may also be tax-free at the state level, depending on the issuer and where you live. Government bonds are generally exempt from state tax but fully taxable at the federal level. Regardless of which type of bond you choose to buy, it’s important to understand the tax ramifications.
Overlooking the Effects of Inflation
Inflation eats away at the value of money. Even a modest 3% inflation rate will steal roughly half of your purchasing power in about 24 years. In other words, if you buy $10,000 in 24-year bonds and inflation remains stable at 3% throughout, the $10,000 in principal you receive upon maturity will only be worth about $5,000 in today’s dollars. This inflation risk is a burden that all bonds carry, and investors need to be aware of it.
Not Planning For Reinvestment Risk
When a bond matures, most investors reinvest the money into another bond or income-producing investment. This exposes investors to the risk that when they reinvest their money, interest rates will be lower than on their original bond.
For example, imagine you have that 10-year bond with a 5% coupon but at the time the bond matures interest rates are only at 3%. Your only choice would be to reinvest your money at that lower 3% interest rate unless you are willing to take on additional risk or consider a different type of investment entirely.
Never Considering Opportunity Risk
When you choose to invest in a bond, you are by definition not investing in something else. If you’re looking for income, for example, you could consider everything from preferred stocks and CDs to income-oriented mutual funds instead of owning the bond you choose. Opportunity risk is the risk that you could earn more if you invest in one of these other types of securities, especially if they carry an equivalent level of risk.
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This article originally appeared on GOBankingRates.com: 6 Common Mistakes You Should Avoid When Investing In Bonds
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