7 Common Pitfalls in Bond Investing and How to Avoid Them

Bonds are fixed-income investments that are often seen as safer than stocks, but investing in them still comes with certain risks. Some of the most common causes of bond losses include changes in interest rates, credit downgrades, and inflation. This article focuses on these factors so you can make better decisions when investing in bonds.

Understanding Trading Losses in Bonds

Losing money is easy if you're buying and selling bonds as a trader. Here are the principal ways that playing with fixed-income securities can cause you 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.

Credit Downgrades

A couple of bad quarters or a punishing one-time event can force rating agencies to consider downgrading the creditworthiness of a borrower. Should even a single notch be chipped from an issuer's credit rating, its bonds will take a significant hit.

Restructurings/Corporate Events

When companies are merged or bought out, their entire capital structure can 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.

Some questions around a restructuring may include:

• What sort of financial shape the companies are in
• What the prospectus of the former bond stipulated
• What the new agreement mandate is

Liquidity-Related Losses (Wide Trading Spreads)

For the most part, fixed-income products trade over the counter (OTC), 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 the price you are able to sell at is $95, or a dollar less than your initial purchase price. The wide spread, in this case, suggests that your trade was generally correct, but you lost where it counted in terms of it being a relatively illiquid market.

The Impact of Inflation on Bond Investments

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.

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 several distinct ways to lose money on these investments.

Deflation

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.

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.

Taxation

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.

Risks Associated with Bond Funds

There are two distinct ways to lose on bond funds.

Redemptions

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.

Poor Asset Management

Losses in funds are more commonly the result of overly aggressive managers chasing after yield from lower-quality issues, which then default. In addition, actively managed funds tend to charge higher fees and create a larger number of taxable events.

Challenges of Investing in Foreign Bonds

Here are four exciting ways to lose your hard-earned income investing in foreign-bond issues.

Exchange Controls

Your foreign-bond-issuing nation decides to impose exchange controls; governmental limitations on the purchase and/or sale of currencies. No money can leave the country.

Currency Rate Fluctuations

The exchange rate between your bond-issuing nation and your own takes a turn for the worse. You will very quickly lose (a lot) of money. The same goes for rising interest rates in that foreign country. Bond laws are universal: The price of your bond will drop as rates rise.

Foreign Taxation

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.

Nationalization

If you're searching for yield in far-off lands, chances are you'll encounter countries where the government can legally take over businesses by decree. When this happens, you will experience firsthand how rating agencies and the markets feel about nationalization (hint: They don't feel good). And that's assuming the corporate bond's obligations aren't immediately declared null and void by the government.

Risks of Mortgage-Backed Securities

Mortgage-backed securities (MBS) are collateralized by the monthly mortgage payments of John Smith. 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 likely a good deal of liquidity. When you finally decide to sell it—if you can sell it—you will lose money.

This is what happened, to the tune of billions of dollars' worth, in the subprime mortgage meltdown of 2008-09.

Understanding Municipal Bond Risks

Here are three ways to lose with municipal bonds, also known as "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.

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 its AAA rating.

Private Issuers

Finally, beware of private companies or organizations that issue municipal bonds under the name of the municipality in which they operate (for example, an airline selling a municipal bond to build a new terminal). Even though the bonds received AAA municipal ratings, the guarantors were private companies—and when and if these companies happened to default, the bond goes under.

Potential Pitfalls of Certificates of Deposit

Admittedly, these are exactly the same as bonds, but since they often serve the same income purpose in a portfolio, we're including them. 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.

The Bottom Line

Understanding the common risks that can lead to bond losses can help you take steps to protect your investments. If you follow the tips provided above and heed the advice about the risks of interest rate changes, credit downgrades, and inflation, you'll be better equipped to make better decisions in the bond market.