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Many people invest in bonds for the relative safety they provide compared to riskier investments such as stocks. But just because some bonds have less risk than stocks does not mean that they’re risk-free, and investors need to carefully assess the downsides of investing in bonds.
Here are five ways you can lose money investing in bonds. Consider whether your fixed-income investments are exposed to these sorts of risks.
1. Rising interest rates
One of the most important things to remember about investing in bonds is that bond prices move inversely to interest rates. That means when rates rise, bond prices fall, all else equal.
Some investors learned this lesson the hard way in 2022, as interest rates have moved off their pandemic lows and marched higher following the Federal Reserve’s decision to hike rates as part of its effort to bring down runaway inflation. A Bloomberg index tracking U.S. government bonds has fallen by about 11 percent in 2022 through August 23, while a fund tracking long-term corporate bonds has plunged more than 20 percent.
In most cases where bond prices decline, the bonds’ coupon payments have stayed the same, but the price falls to reflect the higher level of current interest rates. Long-term bonds are particularly vulnerable to changes in interest rates.
Inflation is harmful to nearly all investments, and bonds are no exception. What may seem like a satisfactory return can quickly get eaten up by even moderate levels of inflation. A bond yielding 2 or 3 percent would essentially have its entire return wiped out if inflation settles at the Fed’s long-term goal of 2 percent.
In 2021, with rates still near record lows, legendary investor Warren Buffett warned about the potential for poor returns from fixed-income assets.
“Bonds are not the place to be these days,” Buffett told Berkshire Hathaway shareholders. “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”
Buffett has pointed out that purchasing a 10-year bond yielding 2 percent is similar to paying 50 times earnings for a business, a key difference being that the bond’s payouts can’t grow. Low-yielding bonds are especially susceptible to having their return wiped out by inflation because it doesn’t take much to eat into their already-low yields.
3. Ratings downgrade
Another thing that can send a bond’s price plummeting is if the issuer’s credit rating is downgraded by one of the major rating agencies such as Moody’s or Standard & Poor’s. Downgrades can happen for a number of reasons but are typically associated with an increased likelihood of the issuer failing to meet its obligations.
A lower credit rating can mean higher debt costs if the issuer needs to raise capital and can also force investors to sell if the bond no longer fits with their investment objectives.
4. Credit default
In the event that a company or government misses an interest payment to bondholders, the bond is considered to be in default. This creates significant doubt around the company’s future existence and whether bondholders can expect to be repaid. Sometimes, there are short-term reasons for the issuer’s default and a solution can be reached, but it’s more likely that bond prices fall as investors try to recover some portion of their investment while they can.
5. Lack of liquidity
You could also be forced to take a loss on a bond investment due to the bond’s lack of liquidity. Though the bond market is larger than the stock market, it can also be less liquid, which means it may be more difficult to quickly sell bonds in the market.
If you need to sell a bond with low trading volume, you could be forced to take a lower price than you expected in order to find a buyer. Trading bonds with low liquidity may make it more likely that you experience a loss on your investment.
Are bonds a safe investment during bear markets?
Bonds may provide some diversification benefits during a bear market for stocks, but there’s no guarantee that they’ll perform well. Historically, some bonds, such as U.S. Treasurys, have been viewed as a safe haven during periods of financial and economic difficulty, causing their yields to fall and prices to spike.
But in the 2022 bear market, bonds have fallen alongside stocks, as rising interest rates have caused most financial assets to decline in value. With bond yields still relatively low, their returns are also negatively impacted by the high levels of current inflation.
Many investors think of bonds as being safe, but there are still plenty of ways you can lose money investing in bonds. Bonds experienced a long bull market that began in the early 1980s and continued as interest rates plunged near zero during the pandemic. But rising interest rates and high levels of inflation have given investors a painful reminder of the risks that investing in bonds presents.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.