Many investors view investment in the fixed income market as a way to protect capital. The irony is that there are many ways to lose money on bonds-some are well-known, some are not many.
Here, we try to investigate the main causes of losses, including literal and actual returns, so that you can learn to avoid potential problems and better prepare for the inevitable.
- Bonds are often touted as being less risky than stocks—and in most cases, they do—but that doesn’t mean you won’t lose money by holding bonds.
- When interest rates rise, issuers encounter negative credit events, or market liquidity dries up, bond prices will fall.
- Inflation can also erode bond returns, as well as tax or regulatory changes.
- Bond mutual funds can help diversify investment portfolios, but they also have their own risks, costs, and concerns.
1. Transaction Loss
If you buy and sell bonds as a trader, losing money is easy. The following are the main ways that using fixed income securities may cause you to lose cash.
Interest rate changes
All bond traders know that when interest rates rise, bond prices fall. If you don’t read the interest rate climate effectively, you will be hurt. This may be the largest source of trading losses in the market.
Several bad quarters or a punitive one-off event may force rating agencies to consider downgrading borrowers’ credit ratings. Even if the issuer’s credit rating drops by one notch, its bonds will be hit hard.
When companies are merged or acquired, their entire capital structure may change overnight. Changes in the corporate structure may cause bondholders to face from a sharp decline in bond value to their investment nothing. Please pay attention to the following factors:
Some questions about restructuring may include:
- How is the company’s financials
- Content stipulated in the original bond prospectus
- What is the new agreement authorization
Liquidity-related losses (wide trading spreads)
In most cases, fixed income products are traded over the counter (OTC), which means that there is not always a lot of visibility on certain issues. You will not have access to all relevant pricing information-especially information about the most important bid-ask spreads. If the spread is particularly large, you may be in trouble.
For example, you might buy ABC company bonds at a price of 96 US dollars, with a bid-ask spread of 88-96 US dollars, and then sell them when they appreciate in value a month later, at a bid-ask price of 95-103 US dollars. But the price you can sell is $95, or $1 lower than your initial purchase price. In this case, the wide spread indicates that your transaction is generally correct, but you have lost in a relatively illiquid market.
Your next chance of losing money comes from inflation. In short, if your fixed income portfolio yields 5% per year and the inflation rate is 6%, then you are losing money. It’s that simple.
Treasury inflation-preserved securities (TIPS) are called “real return bonds” for Canadian investors and should be the answer to the inflation problem. Unfortunately, there are still several different ways to lose money in these investments.
This is not something that happens every day, but it is certainly a possibility.Due to the way the TIPS value is calculated, a longer period of deflation may cause you to return less There is more cash at maturity than you initially invested. Your purchasing power may be intact, but you will show up for less than the cost paid to you by ordinary bonds.
Consumer price index
Changes in the calculation of the Consumer Price Index (CPI) may also bring losses. Similarly, it does not happen every day, but it has been completed, and new calculation methods are regularly tested and promoted to lower your TIPS value.
Finally, TIPS levies taxes on bond yields and capital appreciation (linked to CPI). High inflation is likely to trigger huge taxes, which will make the actual bond yield lower than the inflation rate. Therefore, tax avoidance accounts are most suitable for holding these tools.
3. Bond Fund
There are two different ways for bond funds to lose money.
If there are a large number of redemption requests (resignation of popular managers, suspected corruption, etc.), management may be forced to sell large holdings to pay investors. If these problems lack liquidity, both the fund and investors will suffer losses. In some cases, redemption fees may also significantly increase losses.
Poor asset management
The more common cause of fund losses is that aggressive managers chase low-quality problematic gains and then default. In addition, actively managed funds tend to charge higher fees and generate more taxable events.
4. Foreign bonds
Here are four exciting ways you can lose your hard-earned income when investing in foreign bonds.
Foreign exchange control
Your foreign bond issuing country decides to impose foreign exchange controls and government restrictions on the purchase and/or sale of currencies. Money cannot go abroad.
Currency exchange rate fluctuations
The exchange rate between your bond-issuing country and your own bond-issuing country gets worse. You will soon lose (a lot of) money. So did the interest rate increase in that foreign country. The bond law is universal: your bond price will fall as interest rates rise.
The tax systems of some friendly foreign bond issuing countries are not so friendly. Once the local (foreign) tax officer bites you, you may end up with a lot less. If your rate of return is lower than the rate of inflation, you will fail again.
If you are looking for income on remote land, you are likely to come across a country where the government can legally take over the business by law. When this happens, you will experience firsthand how the rating agencies and the market feel about nationalization (hint: they feel bad). This assumes that the government did not immediately declare the obligations of corporate bonds invalid.
5. Mortgage-backed securities
Mortgage-backed securities (MBS) are secured by a monthly mortgage loan from John Q. Householder. When he encounters personal financial problems, or when the value of his house depreciates significantly, he may default on his mortgage. If enough neighbors join his ranks, your MBS will lose a lot of value and may lose a lot of liquidity. When you finally decide to sell it-if you can sell it-you will lose money.
This is what happened during the 2008-09 subprime mortgage crisis, worth billions of dollars. We all know what this caused.
6. Municipal bonds
Here are three ways to lose money on municipal bonds (also called “municipal bonds”).
Yes, that’s right, reduce. The value of municipal bonds usually lies in exemption from federal taxes—and usually exemption from state and local taxes. As long as these taxes are important, there are advantages to buying municipal bonds. However, when the tax rate falls, the value of holding municipalities and their prices also fall.
In order to maintain its tax-exempt status, securities such as municipal bonds must also comply with stringent legal requirements. But the law will change regularly, and the status of municipal bond issuers will also change. If this happens, your municipality will repricing based on similar, higher-yield (and lower-priced) issues.
For example, municipalities sometimes (though infrequently) lower their credit ratings after the agency decides that the most recent budget contains imprudent expenditures or the investment portfolio suffers significant losses. If the company guaranteeing the bond loses its AAA rating, it may also be downgraded.
Finally, beware of private companies or organizations that issue municipal bonds in the name of the city in which they operate (for example, an airline sells municipal bonds to build a new terminal). Although these bonds have received an AAA municipal rating, the guarantors are private companies-if these companies default, the bonds will go bankrupt.
7. Proof of Deposit
Granted, these are exactly the same as bonds, but since they usually have the same income purpose in the portfolio, we include them. Cashing out your certificate of deposit (CD) early (if permitted) may result in fines. When this fine is offset by accrued interest and inflation, you are likely to lose money.
Will you lose money on bonds and other fixed income investments? Yes, indeed-there are more ways to lose money in the bond market than people think. The good news is that if you know the most common causes of losses, you can avoid them, and you will be better able to avoid these financial misfortunes before they happen.