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It would likely surprise a lot of investors to find out they could lose money investing in bonds. Their first instinct is usually to think back to all the financial advisers they have heard say bonds are safe investments. The truth is that while bonds are certainly more secure than a lot of other investment options, they are far from fail-safe.
In a effort to protect investors from any misconceptions they might have about investing in bonds, we are offering information on the following four ways investors can lose money on bond investments.
FYI: Investopedia.com defines a bond as: “a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.”
Losses From Bond Trading
Much like stock investing where concerns about the total stock return formula matter, investors can buy and sell bonds at will. When buying or selling a bond, the investor is subject to market forces. The pricing process is stated in terms of bid and ask pricing. In the process of buying and selling bonds, the investor is always subject to business activities that can cause a sudden change in a bond’s price. Here’s four ways that can happen:
Interest Rate Moves
From time to time, the US Federal Reserve will move interest rates. When interest rates head upwards, bond prices will move downwards. If an investor is trying to actively trade bonds as interest rates are heading higher, they stand the risk of getting caught paying too much for the bonds they purchase. When that happens, they are stuck with bonds that likely won’t recover in price until interest rates head back down, which could be months or years.
The Credit Rating Effect
The value of a bond reflects the underlying company’s creditworthiness in the eyes of investment rating companies like Moody’s or Fitch. If said rating companies see that a corporation is struggling, they will respond by lowering a corporation’s bond ratings. Investors holding those bonds could take a significant hit until the bond’s ratings go back up.
Corporate Business Decisions
Corporations are always subject to some kind of restructuring process. This could include mergers, selling of assets and bankruptcy filings. Any of these types of events among others could have an adverse effect on the prices of the corporation’s bonds. For the investor, the ultimate risk could be a complete loss in investment value.
Supply and Demand Issues
As mentioned before, markets forces will always affect a bond’s price. There is always the potential an investor will buy bonds at market prices only to encounter a situation where the bid/ask spread is unusually wide at the time they are trying to sell. If selling is mandatory for any reason, they might have to liquidate at the bid price, which could be significantly lower than the investor’s cost basis.
Inflationary Impact on Bonds
There are two ways investors can lose money when inflation starts rising. First, the Fed will usually react to inflation concerns by raising interest rates. As indicated in the section above, rising interest rates would likely have an adverse effect on bond prices.
The second way investors could be adversely affected by inflation is if the relevant inflation rate were to rise above an investor’s return on fixed income investments. In such a scenario, an investor might be earning 5% on their fixed income bond investments but could be losing purchasing power as inflation exceeds that same 5% mark. If an investor were to get hit by both of these inflationary scenarios at the same time, which is likely, they could take a significant hit.
While not as common, it’s worth noting that deflation, sudden changes in the Consumer Price Index and tax laws could also create losses for bond investors.
Investing in Bond Funds
Instead of investing in individual bond securities, investors could choose to invest in bond funds. If you are wondering what is bond fund then let me tell you it is a fund that “sells shares in the fund to investors and uses the money it raises to invest in a portfolio of bonds to meet its investment objective — typically to provide regular income.”
When an investor invests in a bond fund, they give up the ability to make buying and selling decisions other than to get in or out of the fund. The management of the fund’s portfolio falls on the shoulders of fund managers. In such cases, the investor is at the mercy of the fund manager’s investing skills.
There’s two primary scenarios that could drive a funds value down. First, a large redemption request from a large investor or group of investors could force the fund manager to “fire sell” positions to cover the redemption amount. Under the second scenario, plain and simple poor management could hurt the fund’s valuation.
Investing in Municipal Bonds
Some investors prefer to invest in municipal bonds (Munis) under the guise they trust government agencies more than they trust corporate managers. If someone invests in municipal bonds, there are two primary scenarios that can hurt a bond’s value.
First, tax decreases can hurt the demand for munis. When tax rates decrease, astute investors often become more willing to invest in investments that offer a higher return. They will do that because the taxes they would have to pay on such investments would be lower. If investors are selling to move investment dollars, municipal bond prices would likely drop.
Second, government agencies are always subject to changes in regulations, think zoning changes. If regulation changes would adversely affect a municipal bond’s underlying project, a credit rating adjustment might be prompted. That would certainly cause a bond’s price to drop.
None of this information is intended to dissuade investors from investing in bonds. More specifically, the information we have provided here is intended to make sure investors have a full understanding of the risks involved with bond investing.