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. Here we attempt to survey them all, so that you can learn to avoid potential problems and better prepare for inevitable ones.
Tutorial: Advanced Bond Concepts
1. Trading Losses
Losing money is easy if you're buying and selling bonds as a trader. Here are the principal methods to bleed cash.
- Interest Rate Moves
As all bond traders know, when rates go up, bond prices fall. If you haven't read the rate climate effectively, you're going to get hurt. This is probably the single greatest source of trading losses in the market. (Read Managing Interest Rate Risk to learn how to minimize this risk.)
- Credit Downgrades
A couple of bad quarters or a punishing one-time event can force rating agencies to reconsider the credit-worthiness of a borrower. Should even a single notch be chipped from an issuer, its bonds will take a significant hit. (Learn more about corporate and personal credit scoring in What Is A Corporate Credit Rating? and Consumer Credit Report: What's On It.)
- Restructurings/Corporate Events
When companies are merged or bought out, go private - or public - the entire capital structure of the former corporate entity can also change overnight. Changes in corporate structure could leave bondholders facing everything from a steep loss in bond value to a big, fat nothing on their investment. Keep an eye on the following factors:
- Liquidity-related losses (wide trading spreads)
For the most part, fixed-income products trade over the counter, meaning there's not always a lot of visibility in certain issues. You will not have access to all the relevant pricing information - specifically, information about the all-important bid/ask spread. If the spread is particularly wide, you could run into trouble. For example, you might buy ABC Company's bond for 96 when its bid/ask spread was 88/96 and then sell it a month later when it had appreciated and the bid/ask was 95/103 - but your sell price at 95 is still a point less than your purchase price. Illiquidity means your call was right, but you lost where it counted. (For further reading on liquidity risk, see Options Hazards That Can Bruise Your Portfolio.)
Your next opportunity to lose money comes from inflation. Very briefly, 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. Inflation-Indexed Bonds Or TIPS
Here's one that not so many investors are familiar with. Treasury inflation protected securities (TIPS) (called "real return bonds" for Canadian investors) are supposed to be the answer to that inflation issue. Unfortunately, there are still three distinct ways to lose money on these investments.
This is not an everyday occurrence but certainly a possibility. Because of the way values on TIPS are calculated, an extended period of deflation could return you less cash on maturity than you originally invested. Your purchasing power might be intact, but you would emerge with less than a regular bond would have paid you. (To learn more about deflation, read What does deflation mean to investors?)
- Consumer Price Index
Changes in the calculation of the Consumer Price Index (CPI) could also bring losses. Again, not a daily occurrence, but it has been done and new methods of calculation are regularly being tested and promoted to result in a reduction in your TIPS' value. (Read about the differing opinions on how to calculate inflation in The Consumer Price Index Controversy.)
Finally, TIPS are taxed on both the yield and capital-appreciation (CPI-linked) portions of the bond. It's quite possible that high bouts of inflation would trigger significant tax bills that would render the bond's real yield lower than the rate of inflation. Tax-sheltered accounts are therefore best for holding these instruments. (Tax Tips For The Individual Investor can help you keep more of your money in your pocket.)
4. Bond And Money Market Funds
There are two distinct ways to lose on funds.
Should there be a large call to redeem from the fund (on a popular manager's departure, suspicion of corruption, etc.), management might be forced to sell off significant holdings to pay out investors. Should these issues be illiquid, both the fund and investors would realize losses. In some instances, redemption fees might also add significantly to losses. (Read more about the risks surrounding redemption in Common Mistakes By Fixed-Income Investors.)
- Poor management
Losses in funds are more commonly the result of overly aggressive managers chasing after yield from lower-quality issues - which then default. (Read more about whether you should trust your fund manager in Is Your Mutual Fund Safe? and Should You Follow Your Fund Manager?)
5. Foreign Bonds
Here are four exciting ways to lose your hard-earned income using the foreign-bond desk.
- Exchange controls
Your friendly, foreign-bond-issuing nation decides to impose exchange controls. No money can leave the country. Too bad, foreigner.
- Rate fluctuation
The exchange rate between your foreign bond issuing nation and your own takes a turn for the worse. You will very quickly lose (a lot) of money. Same goes for rising interest rates in that foreign country. Bond laws are universal: the price of your bond will drop as rates rise. (Read more about foreign exchange in Floating And Fixed Exchange Rates.)
Some friendly foreign-bond-issuing nations have not-so-friendly tax regimes. You may end up with a lot less once the local (foreign) tax man bites. If you come away with lower yields than inflation, again, you lose.
If you're searching for yield in far-off lands, chances are you'll encounter some with cultures that are unlike our own. In some of them, the government legally takes over businesses by decree. When this happens, you will realize you're not in Kansas anymore - and you will experience firsthand how rating agencies feel about the issue. (Read about one instance of national restructuring in State-Run Economies: From Public To Private.)
6. Mortgage-Backed Securities
This investment offers a rather uncomplicated way to separate you from your money.
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
Here are three ways to lose with "munis".
- Tax decreases
Yes, that's right, decreases. Municipal bonds are generally valued for being exempt from federal taxation - and often from state and local taxes. So long as those taxes are significant, there's an advantage to buying munis. But when tax rates decline, so too does the value of holding municipals - along with their prices. (For background reading on this type of bond, see The Basics Of Municipal Bonds.)
- Changing regulations
In order to maintain their tax-exempt status, securities like municipal bonds also have to adhere to demanding legal requirements. But laws change regularly, and so, too, does the status of municipal-bond issuers. Should this occur, your muni will be repriced against similar, higher-yielding (and lower-priced) issues. For example, municipalities sometimes (though not often) have their credit ratings downgraded after agencies decide that a recent budget contains imprudent spending or an investment portfolio has suffered significant losses. A downgrade might also occur if the company that is insuring the bond loses it AAA rating. (Read more in The Debt Ratings Debate.)
- Private issuers
Finally, beware private companies that issue municipal bonds under the name of the municipality in which they operate (ex. an airline selling a municipal bond to build a new airport terminal). Not a few of these companies have gone on to default - even though the bonds received AAA municipal ratings, the guarantors were private companies. (For further reading, see Fatal Seduction Of The Municipal Bond Insurers.)
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, chances are pretty good you'll lose money. (Read about another risk associated with CDs in Callable CDs: Check The Fine Print.)
There you have it: from the day-to-day to the not-very-likely, there are far more ways to lose money in the bond market than people imagine. The good news is that, armed with this knowledge, you will be better able to avoid these financial misfortunes before they occur.