Bond investments aren’t always as safe as you might think. In fact, for inexperienced investors, it is very easy to lose money when trading bonds. Just like any other investment, you need to look at all possible outcomes, and understand what your risk is.
Bond investing is considered the safest investment you can make, however there are still ways to lose money:
- Moving Interest Rates
- Credit Downgrades
- Restructuring or Corporate Events
- Inflation or Deflation
- Liquidity Related Losses
- Consumer Price Index Changes
- Taxation on Certain Assets
- Poor Fund Management
- Exchange Rate Fluctuation
- Broad Market Decline
- Payment Defaults
- Tax Decreases
- Municipal Bonds Held with Private Issuers
- Penalties for Early Execution
- Mortgage Backed Bonds
- Brokerage Fees
A Brief Intro to Investment Bonds
Investment bonds are contracts that governments or companies issue to raise capital, effectively the bond is a loan, and you are the bank. They offer the investor a fixed income during the life of the bond.
During a bear market, many people seek to invest in bonds as a way of still generating income, bonds are considered the safest investment on the market. Although bond prices move up and down, they are not as volatile as other securities.
There are 7 main types of bond that you will need to know of:
- Treasury Bonds
- Other Government Bonds
- Investment Grade Corporate Bonds
- High Yield Corporate Bonds, also know as Junk Bonds
- Foreign Bonds
- Mortgage Backed Bonds
- Municipal Bonds
How You Can Lose Money With Bonds
Here are the 18 ways you can lose money when investing in bonds… But don’t worry, I’ll tell you how to avoid them.
#1. Moving Interest Rates
If you are new to bond trading you might not know, when interest rates go up, bond prices go down.
If you are invested in bonds, you should keep a close eye on the current climate of the economy. If interest rates are likely to move, you need to find out which way. Yahoo Finance has great predictors which give alerts for rate movement.
Interest rates moving is the biggest source of trading losses in the bond market.
#2. Credit Downgrades
Credit downgrades are particularly important for corporate or municipal bonds. If a company has a couple of bad quarters in a row, or a one-off punishing event, rating agencies tend to reconsider the creditworthiness of the bond.
For Treasury or Government bonds, this tends to be minor fluctuations, however in the corporate world, a single grade down means the bond will take a significant hit.
#3. Restructring or Corporate Events
Companies often have management changes, or acquire new sectors, sell parts of the business, and merge with similar industries. Some of these changes can happen overnight.
Changes in company structure can go one of two ways, and unfortunately for bondholders, we are never that lucky.
Bondholders can see massive losses due to mergers with companies with lower credit ratings, sale of profit centres reducing the businesses revenue, or big capital purchases using the company’s reserve funds. All of these factors can mean your bond isn’t worth as much as it was yesterday.
There is simply no way to tell when a company will change, but you can keep and eye on the following factors:
- What is the reason for the restructure?
- Is the company in a better financial state?
- What the prospectus of the former bond stipulated?
- What the new agreement is?
#4. Inflation or Deflation
The next way to lose money is simple one, if you’re earning 5% returns on your bond investment, but inflation is 6%, you are losing money through buying power. Meaning, even though you are making money, it is not worth anything.
Treasury Inflation Protected Securities (TIPS), often called “Real Return Bonds”, are supposed to be the answer to the inflation problem, as their returns match inflation.
On the other hand, if you invest in TIPS deflation can counteract the Real Return Bond. After an extended period of deflation, you could see a return of less cash on the maturity of your bond. Your buying power would be the same, but you would lose money on the overall trade.
#5. Liquidity Related Losses
Most of the time, fixed income products such as bonds are sold ‘over the counter’, so there’s not a lot of visibility in certain issues.
You will not have access to the relevant price information, or the information about aspects such as the bid/ask spread. If the spread is wide you could run into problems.
You buy a corporate bond for $100 when it’s bid/ask spread is $92/$100.
1 Month later, the bond has appreciated and hit maturity, but the bid/ask is now $99/$107. So… The bond has went up in price, but because the spread was so wide, you still sell at a loss.
This is liquidity related losses. Your trade was correct, the bond went up in price. However because of the illiquidity of the trade, you lost money.
#6. Consumer Price Index Changes
The consumer price index (CPI) is the measure that examines the weighted average of prices of a consumer goods and services. Changes in CPI are used to assess the price changes associated with the cost of living. The CPI is most frequently used for identifying inflation or deflation.
Changes in CPI are not something you have to worry about day-to-day, but they are important.
Like inflation, if the CPI increases, the value of your bond decreases. New methods of calculating the current CPI are always being tested, the result is a massive decrease in value of all TIPS and corporate bonds.
You will need to check up with finance sites such as Bloomberg or Yahoo Finance for updates of the CPI. If they are on the 6 o’clock news, it usually means something bad.
#7. Taxation on Certain Assets
TIPS are taxed on both the yield and the capital appreciation portion of the bond. It is more than possible that high inflation rates would result in big tax bills that would make the bonds yield lower than the rate of inflation.
This is a complicated piece of tax legislation, and it depending on where you live, it might be difficult to avoid this problem.
The only sure fire way to fix this issue is to form a tax sheltered account, whether that be a limited company or LLP. Speak to your accountant first!
If you prefer to invest in bond funds rather than individual bonds, like myself, this is relevant to you.
If investors call for a large redeem from the fund, management might be forced to sell off large sums of holdings to pay out. If mass sell offs occur it could mean huge losses for both the fund and the investors.
In some cases if the redemption can be handled with liquid cash it isn’t that much of an issue.
Be on the look out for certain activity which could lead to investor suspicion. Events such as, popular managers departing, suspicion of corruption, or corrections in the wider market could all lead to a redemption.
#9. Poor Fund Management
This one is simple, if you invest in a bond fund and that fund has a drunken sailor at the wheel, likelihood is… You’ll lose money.
Overly aggressive managers chasing huge yields from low quality bonds often see those bonds default.
Before investing in a bond fund, look at its history, prior returns and any major changes in the last 5 years. You should also look at the fund manager, check their prior appointments and overall strategy, most funds have a manager profile which outlines his intent with your money.
#10. Exchange Rate Fluctuation
Many bond investors look internationally for opportunity. So one thing you must always consider is… The currency exchange rate.
Currency exchange rate doesn’t fluctuate to much to fast, but if you have a bond with a 10 year maturity, the exchange rate of USD to EUR could be very different.
Not only the currency, but the exchange controls could pose an issue. If you are invested in a foreign bond and the nation declares exchange controls, it could put limitations on the purchase or sale of that currency. Meaning no money can leave the country.
There is no way to tell what the exchange rate will be in 10 years. Your best bet is to stick to local bonds, or invest in a fund that deals internationally.
This is far from an often occurrence!
If you are looking for yields in far away countries, you might encounter governments that can legally takeover businesses by decree.
If this happens you will see just how quickly a rating agency will cut your bond in half. Governments are not known for running businesses, and the bond market know it, so it is likely that your security will be worthless if the company becomes nationalised.
Also the Government has no obligation to uphold the bond, they can declare it null and void upon takeover of financial control. This is one of the few ways you can lose 100% of your money.
To get past this one you’ll need to be careful. The only reason a company would become nationalised is if it contributes massively to the economy, but is struggling financially. Many banks and healthcare companies have become nationalised over the last century.
#12. Broad Market Decline
If a market decline happens, or a market correction, it could mean companies fall into financial difficulty.
In a bear market, bonds become desirable as they are a fixed income source. But what a lot of investors fail to notice, when a company is decreasing in share price, it usually means they are financially struggling.
A company that is struggling to consolidate its assets and find cash will not be able to pay bondholders their premium. Therefore they will default on the bond, making it worthless.
Not all companies follow this pattern in a market correction, it is usually industry specific. Most of the time bondholders will be paid first if a company goes into administration, but it is important to stick to stable companies with a strong balance sheet.
#13. Payment Defaults
Defaults are when the bond issuer can no longer pay the interest on their bond. For fixed income investors such as bondholders this is massively inconvenient.
This is the biggest risk for fixed income investors, and can result in your bond investment becoming void.
If you are risk of losing the entire value of your bond due to a company going into administration, bondholders usually have legal rights to receive whatever the principle of the bond value was when purchased.
To minimise the risk of this happening you could own what is known as a basket of bonds, where you diversify your holdings into separate companies.
#14. Tax Decreases
This is a weird one, because as most of you will expect… When taxes go down, it’s a good thing. But that is not always the case for bondholders.
Municipal bonds have the benefit of being tax exempt of Federal taxation, and in most of the United States are also exempt from local taxes. So as long as the taxes are high, they are good investments.
However when taxes decrease, Municipal bonds become undesirable because they are risky investments. If taxes are low, their are better investments out there.
#15. Municipal Bonds Held with Private Issuers
Beware of private companies that issue municipal bonds under the name of the municipality in which they operate. For example, an airline might sell a municipal bond to build a new terminal.
Even though the bond gets a AAA rating from the agencies, the guarantors were private companies, and if these bonds default, the value of the municipal is void.
Just do your research and be careful. Always buy through a registered broker, or direct from the issuing company.
#16. Penalties for Early Execution
This applies to bonds and the banks solution to bonds… Certificates on Deposit.
Cashing in your CD early can trigger a penalty. When the penalty is netted out against your earnings, you might see that you’ve lost money on the overall investment.
Only some bonds give penalties for early execution of maturity, so before purchasing make sure to ask these questions:
- How long is the bond maturity?
- Is there a penalty for early execution of the bond?
- Do you charge any fees for early execution?
Corporate bonds can be surrounded by complicated legislation, but don’t be afraid to ask as many questions as you want.
#17. Mortgage Backed Bonds
This is a wide topic with good aspects and terrible consequences. For the purpose of this article I’ll be focusing on the terrible ones, but don’t let this discourage you from finding out more.
Mortgage backed bonds are collateralised by a monthly mortgage payment from the homeowner. If this homeowner has a string of unlucky circumstances and finds himself in financial difficulty, he may default on his mortgage.
This could mean you bond loses massive value as it is no longer producing a fixed income. If the homeowner doesn’t get back on his feet, your only choice would be to sell the bond at a huge loss, or watch it become void.
Another way mortgage backed bonds can lose you money is through a fall in house prices. If you hold a bond on a $400,000 house, and the house price decreases to $300,000. The mortgage amount would decrease, therefore your bond value would decrease.
Overall mortgage backed bonds have a lot of ways to lose money. Unfortunately it is all out of your hands, it is down to the financial savviness of the home owner, and the housing market in the local area.
#18. Brokerage Fees
Brokerage fees are the worst. If you are still using a traditional broker or financial advisor, you might want to check out the online equivalent.
You should always consult with a financial advisor before making decisions with your money, but 9 times out of 10 they’re going to want a slice of your profit. So how about using something easier like eToro, M1 Finance, or Trading 212.
All of these brokers are free to signup and use. With low spreads and no commissions you can save yourself hundreds if not thousands of dollars.
If you want to find out more you can head over to their websites via the links above, or check out my platform reviews below:
The final thing to be said is…
Even if you follow every rule and dodge every scam artist, there is still a chance you will lose some money. We are not perfect, and I don’t expect any of you to be, so don’t be discouraged if a trade goes bad, because the next one could be great.