It is true that bonds are supposed to be a fail-safe type of investment, but the truth is that a bond investment is just like any other investment: they are not fail-proof and it is possible to lose money and to lose it big in bond investments. Just ask investors who put money in some of the bankrupt governments or banks in the Eurozone and they can tell you better how they are still trying to save what is left of their fingers after getting them burnt.
Exactly how do losses occur in the bond market and how can investors prevent themselves from losing money investing in bonds? Here are a few tips to serve as a guide.
Tips to Avoid Losing Money Investing in Bonds:
Did you know that Standard & Poor’s, one of the top-notch credit rating agencies, had Lehman Brothers still rated as Triple A just a month before the cards came crashing down at that company, triggering the 2008 global financial crisis? Or that AIG was still carrying its top credit rating at the time that the US Government stepped in with an 11th hour bailout that prevented what would have been a monumental catastrophe in the global financial system? Indeed, some of those subprime mortgages were all carrying AAA credit rating status at the time they all collapsed one by one.
The 2008 global financial crisis and the antecedents that led to it are a clear example of how unrestrained belief in the credit rating system can mislead investors. The aftermath of the global financial crisis in which the same credit rating agencies are still in business without any sort of punitive action taken against them for misleading investors, is another reason why every bond investor must perform his or her own due diligence before investing in any government, municipal or corporate bonds. If you are careless about this fact and lose money, chances are that the credit rating agencies will not give you your money back. So protect yourself before anything goes wrong.
Tip No. 2: Do some due diligence on the borrower
A bond issuer is a borrower, and just like any other borrower, you must be sure of the entity’s ability to pay you back your money. The problem with bonds is that the borrower or bond issuer is not depositing any collateral for your money. You are basically relying on the word of the bond issuer to pay you back based on the terms represented on your certificate. You cannot afford in these circumstances not to conduct some checks on the credit worthiness of the bond issuer to know if you have a good chance of getting your money back. For instance, supposing a company A is issuing a bond in order to clear debts at a time it has an overbloated overhead bill, and another company B is issuing a bond to expand a business operation which is profitable, which of the two companies would be more likely to pay back if conditions do not change? The answer should be pretty obvious.
Tip No. 3: Beware of Inflation
You need to be wary about investing in sovereign debts of countries that do not have a structured and institutionalized plan for dealing with inflation. Once a fixed-return bond is purchased and the interest payment is set, there is no way of changing this interest. So if the rate of inflation starts to rise and outstrips the interest payment on the bond, the bond is a loser. So only by a fixed-return bond in a situation where the inflationary rate is not subject to northward movements.
Tip No. 4: Hold Your Bonds to Maturity
This seems to be an area where many retail investors get it wrong. The investment disclaimer that advises investors to only “trade with money that they can lose” holds very true in the bond markets. A modification of this disclaimer would be to advise potential bond buyers not to use money that they require for essential expenditure for bond investments, so that they can actually leave any bond investments to mature. Allowing the bond to mature before selling is the only way that all interest payments plus the principal is obtained in full. Bond prices are subject to change, and selling a bond prematurely will lead to loss of money because such bonds end up being sold for a lesser price than they were bought.
Tip No. 5: Never invest in corporate bonds from the same sector
When investing in corporate bonds, it is always better to spread the risk by investing in bonds in different sectors. Never hold on to bonds in the same sector, so that a sectorial collapse doesn’t ruin your investment. You can imagine the fate of some investors who put all their bond investments in the housing market or subprime mortgage market in the US when the bubble popped.
Tip No. 6: Diversify your portfolio
This is a spin-off from the point mentioned above. There is wisdom in spreading your bond investments to cover different maturity dates, according to your circumstances or stage in life. For instance, a younger person may wish to invest in a 10 year bond for the education of his or her kids, a five year bond and a short-term bond. Those who are near retirement are obviously not going to benefit from a long term bond which is more risky anyway, so shorter term bonds may be more appropriate for this age group.
You can see from all the tips presented above that bond investments require vigilance and smart thinking on the part of the investor in order to safeguard them and not to lose money. When these tips are followed to the letter, the chances of losing money on a bond investment are far reduced.