8 Ways To Lose Money On Bonds
Most investors are familiar with the most common ways of losing money in the fixed-income market, but there are other, lesser known - and equally effective - ways to drive yourself to the poorhouse using fixed-income securities. Read on to learn how to avoid potential problems and better prepare for inevitable ones.
1. Trading Losses
Losing money is easy if you're buying and selling bonds as a trader. The following four methods can cause a cash hemorrhage:
- Interest Rate Moves: When interest rates rise, bond prices fall. If you haven't read the rate climate right, you're going to get hurt.
- Credit Downgrades: If rating agencies reconsider a borrower's creditworthiness, its bonds will take a big hit.
- Corporate Restructuring: If companies merge, are bought out, go public, etc., the capital structure will change dramatically. Watch for the reasons why the change has occurred, the company's financial health, the former bond's prospectus and what the new agreement mandate is.
3. Treasury Inflation Protected Securities
Treasury inflation protected securities (TIPS) may solve the inflation issue, but you can still lose money:
- Deflation: With the way values on TIPS are calculated, an extended period of deflation could return you less cash on maturity than you originally invested.
- Consumer Price Index: New methods of calculating CPI could result in a reduction in your TIPS' value.
- Taxation: TIPS are taxed on both yield and capital-appreciation. High inflation can create big tax bills, lowering the bond's real yield.
4. Bond and Money Market Funds
There are two ways to lose money on bond funds and money market funds:
- Redemptions: Upon a popular manager's departure or suspicion of corruption, management might be forced to sell off holdings to pay out investors. If issues are illiquid, both the fund and investors realize losses.
- Poor Management: Losses in funds are most commonly the result of overly aggressive managers chasing after high yields from lower-quality issues that often default.
5. Foreign Bonds
If you are holding foreign bonds, there are four ways to lose your money:
- Exchange Control: Your friendly, foreign-bond issuing nation decides to impose exchange controls that prevent money from leaving the country.
- Rate Fluctuation: Bond laws are universal - the price of your foreign bond will drop with rising foreign interest rates
- Taxation: You may end up with a lot less if the local (foreign) tax man bites, as some foreign-bond issuing nations have less-than-friendly tax regimes.
- Nationalization: In some countries, the government can legally take over your businesses by decree.
6. Mortgage-Backed Securities
Mortgage-backed securities (MBS) are collateralized by the monthly mortgage payments of John Q. Householder. When he runs into personal financial problems, or when the value of his house depreciates significantly, he may default on his mortgage. If enough neighbors join him, your MBS will lose a great deal of value and will likely trade without liquidity. When you finally decide to sell it, you will lose money. (Read about an example of mortgage default on a large scale in The Fuel That Fed The Subprime Meltdown.)
7. Municipal Bonds
Municipal bonds, or "munis", offer another three ways to lose your money fast:
- Tax Decreases: Munis are valued for being exempt from federal (and often state and local) taxes. If tax rates decline, the value of munis declines - along with their prices.
- Changing Regulations: Munis need to adhere to demanding legal requirements. If laws change, your muni will be repriced against similar higher-yielding and lower-priced issues.
- Private Issuers: Buyer beware. Some private companies will issue municipal bonds under the name of the municipality in which they operate. With these, the guarantors are private companies, not the municipality.