4 Essential Investment Tips To Help You Avoid Bond Defaults
- December 30, 2016
- Category: Finance, Markets
The global bond market is like a vast arcade for securities. Investors, big or small, have numerous investment options and can diversify their profiles by adding different debit and credit investment opportunities.
Investors interested in debt investments usually go for bonds. Bonds are debt investments, wherein the investor lends (loans) money to an entity, corporate or governmental, for a defined period of time at a variable or fixed interest rate. The funds collected are used by firms, municipalities, state administrations, and the federal government to finance multiple projects.
If you are a debt holder (owner of bonds), you are entitled to benefits like a steady interest (coupon) from the corporate or government-issued bond. However, there are times when bond issuers become insolvent at a much lower rate/value than anticipated. Unforeseen circumstances, poor management, or unfavorable market trends can lead to an issuer defaulting on debt, leaving a number of investors without any returns.
Bond default occurs when an issuer fails to pay interest or principal amount within the maturity date. Defaults can become a major concern for investors with fixed revenue streams. They prefer investing in bonds from issuers that are likely to fulfill their promises.
Follow the tips mentioned below to protect yourself from bond defaults:
1. Read and Understand the Official Statement of the Bond
Whether you are a seasoned investor or a beginner, ask your investment adviser for information about the securities you are interested in. Read the bond’s official statement thoroughly before you purchase it. The document contains all important details regarding the plausible risks and sub-clauses and the features of the security. Discuss the pros and cons of the bond, and the likelihood of default in all the securities you wish to invest in.
Remember, not all issuers have official statements prepared for the bonds. These are the securities that amount for less than USD 1 million or are sold primarily to institutional investors. Make sure you ask your adviser for the most up-to-date details of the bond, as some of the information mentioned in official statements of outstanding bonds may not be current.
2. Yields Are Accompanied by Risks
Investing in bonds by governmental issuers will be less risky; however, the possibilities of high yields can be riskier for investors. Greater yields generally mean greater risks of defaults. In a low interest rate market, you may be tempted to purchase securities that offer greater yields. But, be prepared for a greater possibility of not receiving desirable returns with these investments. If you are not comfortable with risking losing your money, simply avoid them.
An individual investor is in a better position to buy a mutual fund because this type of a fund promises several benefits and is a low-risk investment option. Mutual fund issuers appoint a professional investment team to the investors, and help them diversify their investment portfolios with different offerings.
3. Ask Your Adviser for Bond Disclosures
All financial institutions and brokerage firms selling bonds (corporate or governmental) are mandated to have fixed procedures for investors to obtain documents for the securities and other disclosures. Ask your broker if the issuer of the bond has certain information, like its performance reports and annual financial/operating data, readily available for the investors. Any missing or outdated financial report can be treated as a potential red flag.
The credit ratings of the company’s stocks can help you evaluate its bond’s default risk as well. You need to understand that these ratings are given by rating organizations based on past performance and factors impacting the market. There is a high probability that an entity rated with high credit ratings will meet its financial obligations on time. Because credit ratings vary with time, do not consider them to be equivalent to the official statement. Be sure to ask your financial adviser for the current published ratings on the bond you wish to invest in.
4. Diversify Your Investment Portfolio
Global market trends can directly or indirectly impact regional markets. For instance, there are several global factors that led to losses incurred by individual investors, due to rise in cases of bond default in Puerto Rico. In such situations, market risks may be mitigated to a certain extent by diversifying the types of securities you add to your portfolio. These investments may be among different asset classes or within the same asset class.
Consult your financial adviser before you diversify your investment portfolio. He/she will be a better judge of matters related to the municipality bond asset class, and guide you with diversification options like going for varied issuers, location or maturity dates. The key is to research the securities in a given mutual fund or exchange-traded fund (ETF) and the maturity lengths of the bonds. Try to avoid longer maturities as they usually mean greater risk.
Individual investors can avoid the risk of facing bond defaults by going for securities with high credit ratings, government-issued bonds, or the lower-risk bond funds. This can be done through intensive research and consulting genuine financial advisers. At the same time, as an investor, you need to keep in mind that there is an equal possibility of a default because of fluctuations in the market segments. Therefore, do not invest your money without being completely thorough with the risks that they may entail.
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