8 Ways To Lose Money On Bonds

AAA

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.

2. Inflation

Your next opportunity to lose money comes from inflation. If you're earning 5% per year in your fixed-income portfolio and inflation is running at 6%, you're losing money. It's as simple as that. (For further reading, check out Coping With Inflation Risk and Curbing The Effects Of Inflation.)

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.

8. Cashing In Your Certificate of Deposit

Cashing in your certificate of deposit (CD) early (where permitted) may trigger a penalty. When this penalty is netted out against accrued interest and inflation, the chances are pretty good that you'll lose money. (Read about another risk associated with CDs in Callable CDs: Check The Fine Print.)
Related Articles
  1. Retirement

    Should I Invest in Bonds After I Retire?

    Yes, retirees should invest in bonds, but remember that not all bonds are safe investments. Seek the help of a financial advisor.
  2. Investing News

    Money Market vs. Short-Term Bonds: A Compare and Contrast Case Study

    Discover characteristics of money market and short-term bonds, including how the investments are alike and different, and the benefits and risks each offers.
  3. Retirement

    Bond Basics: Conclusion

    Now you know the basics of bonds. Not too complicated, is it? Here is a recap of what we discussed: Bonds are just like IOUs. Buying a bond means you are lending out your money. Bonds are ...
  4. Mutual Funds & ETFs

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  5. Retirement

    Top Uses For Bonds

    Find out what bonds can do for your investment portfolio.
  6. Bonds & Fixed Income

    Top 8 Ways Lose Money On Bonds

    Find out what these common ways are so that you can avoid them - and the losses that follow.
  7. Home & Auto

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  8. Options & Futures

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  9. Options & Futures

    20 Investments: Corporate Bond

    What Is It? Similar to a mortgage with a bank, bonds are an issue by a borrower to a lender. When you buy a corporate bond, you are loaning your money to a corporation for a predetermined period ...
  10. Bonds & Fixed Income

    Cash Vs. Bonds: What to Pick in Times of Uncertainty

    Learn about the benefits and drawbacks of holding cash versus investing in bonds to ensure you make the right decision about how to best safeguard your money.

You May Also Like

Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  4. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  5. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  6. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
Trading Center