Oran Hall | Bonds are risky too

Bonds are popular with investors who are keen on the safety of their principal, expecting to receive all of their principal on the maturity date.

The experience of some investors, including the elderly who rely on them as a source of retirement income, however, is proof that bonds are not absolutely safe.

Like all other forms of investment, quality matters. Thus, there are good quality bonds and poor quality bonds, and quality can change during the life of a bond if there are material changes in the financial position of the issuer.

The issuer of a bond is expected to pay the agreed interest on the contractual date, and principal on the specified maturity date. Many do. There are, however, cases in which the issuer pays interest regularly but fails to re-pay the sum borrowed – the principal – in full or at all.

In some cases, with the permission of the bondholders, the borrowers have been able to extend the maturity of the loan.

Sometimes, though, there are indications that the issuer is having problems as there are delays in making interest payments. In very bad situations, they may even miss interest payments.

While bonds tend to be a reliable source of interest income and generally give investors some comfort that their principal is safe, the horror stories of some investors, especially the vulnerable, such as pensioners, raise questions about how their quality is assessed, how they are aligned to the needs of investors, what consideration is given to diversification, how securities dealers decide which bonds to source for their clients, which bonds investment advisers recommend to their clients, and how equipped some advisers are to address the needs of their clients.

There are not many local bonds on our market. There are, however, bonds issued in several countries that are available. Some are government issues, others are corporate issues – and the quality varies.

International bond rating agencies offer a service that allows investors and advisers to make informed decisions, especially when trading international bonds. Where such ratings are not available, it is reasonable to expect local dealers to do their own research and analysis and to draw from that of analysts in the markets in which the securities are issued.

Local dealers owe it to their clients to keep current with developments in the markets and to assess the likely effects on their clients and, where possible, assist them to make adjustments to their portfolio if deemed necessary.

Although the decisions about the instruments being made available to clients most likely rest with relatively senior individuals in the financial institutions, it is reasonable to expect the advisers who interface with the clients to have a good understanding of the instruments, the risks associated with them, and the needs and circumstances of their clients.

That some investors have lost their entire investment, based on what I have seen in the press and the accounts of readers of my column, it seems that investors have sometimes been exposed to unnecessary risk by nearly all of their funds being put into just one bond.

Apart from that, there tends to be a preference for bonds with relatively high returns. It is to be expected that the longer the term of the instrument, the higher the interest rate.

However, when the rate on bonds with similar terms varies meaningfully, investors should think thrice before committing any of their funds to those offering the highest rate. Generally, these are riskier – the higher rate being an inducement to invest, or compensation for the higher risk.

Further, investors should avoid investing all of their funds in just one bond no matter how attractive it seems. The risk is just too great.

Licensed securities dealers that deal in bonds can protect their clients in several ways. They can take greater care in selecting the bonds they offer to their clients. They can put officers in place to review the portfolios of their clients and determine if they are over-exposed to a particular issuer, for example.

They can send regular updates to their clients about the bonds they own. They can provide client education to equip them to make better decisions, because it is the clients who should make the decision based on their interaction with their advisers and their understanding of their own needs and objectives. In other words, the role of the adviser is to make recommendations.

Investors have responsibilities too. They should educate themselves about the instruments available, even if it means getting others to assist them. They should try to understand the risks to which they are exposing themselves and avoid putting all of their money, especially large sums, into just one bond.

They should not rely solely on one financial institution for guidance, and – especially older individuals – should have a younger and more informed and trusted family member or friend join them in their interactions with the investment adviser as much as possible.

There are risks in investing in bonds, notwithstanding their general acceptance as safe instruments, but the licensed securities dealers who serve the very important function of making them available to the investing public have a serious role in protecting investors. Investors, too, have a responsibility to protect themselves. After all, it is their money.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com