06. Aug 2019

Bonds – five mistakes fixed-income investors should avoid

Interest rates are low, but bonds still belong in a balanced portfolio. Investors should be aware of certain issues.

  • Bonds often react sharply to changes of base rates, but long-term investors should not pay too much attention to these fluctuations.
  • It is more important to keep an eye on inflation.
  • Like equity investors, bond investors should understand the issuer's financial situation.
Reading time: 3 minutes

Risk-averse investors often invest a portion of their assets in bonds, in fact fixed-income securities can make a sensible addition to a portfolio. In certain market phases, bonds and equities are often uncorrelated, so that losses in one investment type can be offset by gains in the other. Furthermore, regular interest payments from fixed-income securities can add stability to a portfolio.

Government bonds and investment-grade corporate bonds are considered particularly low-risk. These are fixed-income securities that rating agencies such as Morningstar and Moody's rate as being at particularly low risk of default. However, this dependability does not come for free. Investors must usually accept low interest from such securities, and in extreme cases they can even slide into negative territory. In such cases, investors are actually paying to hold these lower-risk securities in their portfolios.

Overall, investing in bonds can definitely make sense – provided investors avoid some classic mistakes.

1. Do not overreact to short-term interest rate fluctuations

Base rate trends have a significant impact on bond prices. If interest rates rise, the prices of many bonds fall, and vice versa. If you invest directly in bonds, these fluctuations cannot be avoided over the term of the bond.

But the same thing applies here as with equity investments: patience pays off. If an investor holds a bond to maturity, the bond’s full nominal value is paid out. The investor achieves the return promised at the time of purchase, and any interim price fluctuations do not affect the outcome.

If the bond is sold early, the situation is different. In that case, depending on how the bond’s price has moved, the investor may sell the security at a profit, but also at a loss. The outcome is therefore more predictable if the bond is held to maturity.



To the article: "Bonds - falling interest rates may cause yields to crumble"

Short-term price drops should not worry long-term investors.

Long-dated bonds usually provide more stability than short-dated bonds.

2. Do not overestimate the advantages of short-dated bonds when the yield curve is flat

When the yield curve is flat, some investors are tempted to switch from long maturities to short maturities. Experts talk of a flat yield curve when short-dated bonds have a similar yield to long-dated bonds. In that scenario, why should investors tie up their assets for a long time if they are not rewarded for doing so?

The answer has to do with risk distribution in the portfolio. The reasons for buying bonds are typically low risk and stability. If the stock market plummets, long-dated bond prices often conversely go up and may offset any losses. Investors who switch too soon to short-dated bonds give up this advantage.

3. Do not ignore inflation

For bond investors, the inflation rate is far more important than short-term interest rate trends. Particularly for long-term investments, there is a risk that inflation will eat up earnings over time.

In Germany, the inflation rate has fluctuated between one and two per cent since 2017. Recently, the consumer price index rose to 1.6 per cent year-on-year[1]. In this scenario, a ten-year bond that is to be held to maturity should pay interest of at least two per cent to be a worthwhile investment. Investors who are satisfied with low interest rates and do not take inflation into account may ultimately lose some of their assets.

It can nonetheless make sense to include a low-interest bond in a broadly diversified portfolio, to provide better risk diversification for example. In that case, other investments, such as equities and high-yield bonds, should ensure that the portfolio's total return exceeds inflation.

The portfolio’s total return should always be above the inflation rate.

Higher returns usually go hand-in-hand with higher risk.

4. Do not underestimate the risks of high-yield bonds

High-yield bonds are attractive because of their higher payouts. However, this attractive-looking promise of high interest always comes with higher risk. The bond issuers could get into economic difficulties and fail to pay the promised interest or to repay the bond’s face value. In such cases, investors should consider carefully whether the higher interest rate is worth the risk.

If bonds are meant to stabilise a portfolio, only a small number of high-yield securities should be included. This is especially true of corporate bonds. Companies often find it difficult to service their debts when stock markets fall, which means risks rise in both the equity and bond asset classes at the same time, reducing bonds’ stabilising effect. Government bonds and investment-grade corporate bonds, by contrast, often benefit from falling stock markets but offer comparatively low interest rates.

5. Do not blindly trust ratings

Just because a bond is categorised as particularly safe by rating agencies, that does not mean all credit risks are excluded. Rating agencies can be wrong. Furthermore, they are often relatively slow to react to new developments. Investors should therefore never omit to make their own assessment of the issuer's business prospects before investing. Are the fundamentals sound? Is the economic environment good? Have there been any recent developments that could have impacted on the success of the issuer's business? Investors should only seriously consider committing when these questions have been answered to their satisfaction.

Conclusion

Bonds can contribute to risk diversification, but careful selection is essential. Investors should pay particular attention to inflation and fundamental data on the issuer’s business. Investors who want to sleep well at night, you should also think long term and hold bonds to maturity regardless of interest-rate fluctuations.

To reduce default risks, bond investors should not put all their eggs in one basket. Maximum diversification significantly reduces risk and generally leads to higher returns in the long term. Bond funds offer a particularly good way of achieving this. Bond fund investors benefit from better diversification than individual bond buyers. Furthermore, fund managers take on the task of assessing and selecting individual bonds. DWS offers investors a wide range of different bond funds.

Stay in control: before investing in bonds, investors should always form their own view of the issuer.

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1. German Federal Statistical Office, July 2019

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