While bonds are traditionally considered a safer, more conservative investment than stocks, it is possible to lose money in bonds. Yes, you read that correctly. In order to protect your principal while investing in bonds, be wary of the following:
Interest rate fluctuations
Bond prices decline when interest rates rise. If you incorrectly predict the direction in which interest rates are heading, you could lose money with your bonds. However, if you hold the bonds to maturity and the issuers don’t default, then you will get back the full face value of the bond regardless of interest rates in the marketplace.
Credit rating agencies
Companies and governments are both susceptible to downward ratings of creditworthiness by credit rating agencies. A bad quarter of earnings or a reported event might trigger action by the credit rating agencies. Investors can lose money on a decline in the bond issuer’s credit rating.
Inflation
You will lose money if the earnings in your bond portfolio don’t outpace inflation. When inflation is running high, consider using U.S. Treasury inflation-protected securities or inflation-linked corporate and municipal bonds. Even though these inflation-linked securities offer lower interest rates than non-linked issues, their linkage to inflation could protect your purchasing power.
Restructuring
Mergers, acquisitions, and capital restructuring are standard occurrences in the business world. Corporate bonds can drop in value when a major change occurs in the company. Reviewing the reasons for the changes in the corporation and the overall financial shape of the company might not avoid the problem, but it might help you determine whether to hold the bond or sell it.
Exchange controls
If you own bonds issued in a country other than your own and do not know what exchange controls are, take a seat. Exchange controls are how the country in which the bonds were issued imposes a ban on the removal of money from its borders. In some cases, governments might restrict the flow of capital out of their borders (as Cyprus had to do to protect its banking industry in 2013). If that happens at a time when you expect to receive an interest or principal payment from a bond issued in that country, you might be stuck holding a worthless security.
Foreign currency exchange rate fluctuations
When there are unfavorable currency exchange rates between the country in which you live and the country where the bond was issued, you may lose money.
Foreign nationalization
You want to achieve global asset allocation for your retirement portfolio, so you decide to invest in bonds in a country with which you are completely unfamiliar. After purchasing the bonds, you discover that the government of the tropical paradise in which the issuing corporation is located just nationalized all of the businesses in the country. The government now owns the issuer of your bond and may simply choose to default on the loan.
Liquidity
Just because you want to sell a bond you own, you may not be able to find a buyer. Bonds tend to be less liquid than stocks, which means that if you need the money right away, you may have to sell the bond for a much lower price than you would have expected, or you may possibly not be able to sell it at all.
Municipal bonds may not be tax free
Municipal bonds are much more complicated than they appear. One big risk that often surprises investors is when they discover that these tax-free bonds aren’t actually tax free at all. A common case of this is when people move to Israel and discover that their “munis” are taxable in Israel. The Israeli tax authority does not view these bonds as tax free, so make sure that you update your portfolio when you leave the United States.
For more information on this topic, read Is it Easier to Make Money or Lose Money?
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published February 21, 2017.