Absolutely.
How do you Lose Money in Bonds?
Two main reasons:
1) The borrower cannot repay you – called credit risk
2) Interest rates move up – called interest rate risk
Sound complicated? Fear not, it’s simple. Let’s break these terms down.
Credit Risk
When you buy a bond you are lending someone (a government, a corporation, etc.) money. In return, they pay you money for this loan (typically called a coupon or interest rate). They also must pay you back all of the money you lent them on a set date.
If the borrower defaults, you are out of luck. A default is when the borrower is not able to pay the interest they promised you or if they cannot pay back the money you leant them. An example of a recent and widely publicized bond default was Lehman Brothers in 2008.
Interest Rate Risk
When you buy a bond, you are not lending people money out of the kindness of your heart (although you are very charitable). You are lending money/buying a bond to make money. The amount of money you make (annually) is called your “interest rate” on the bond.
So let’s say you bought a bond for a 2% interest rate. Then, three weeks later interest rates in the market start moving up. You can now buy that same bond at 2.5% instead of 2%. All of a sudden, your bond becomes less valuable because everyone is buying the bond at a 2.5% interest rate.
The price of your 2% bond therefore goes down when interest rates rise since no one wants to buy it (supply and demand). This is why people say, rising interest rates are bad for bonds.
So, You Always Lose Money If Rates Rise?
No, not necessarily. If you own an individual bond you can always hold that bond until maturity rather than sell it for a loss. In that case, you will make 2% annually, an overall gain, but a relative loss compared to the 2.5% bond.
In a mutual fund, you don’t have the option to simply hold a bond until maturity. Why not? In a mutual fund, there are thousands of investors who can buy and sell every day. So while you may want to just hold that 2% bond to maturity, someone else may want to sell the fund — and with that goes a share of your 2% bond at a loss.
Interest Rate Risk: What to Be Careful of Today
The longer the maturity on a bond, the more extreme the decline in value will be when interest rates rise. As such, today, people are taking a careful look at the maturity of their bond funds and their bond portfolios. Why? Interest rates have fallen so far it seems likely they will rise in the future causing declines in bond values.
Related Articles: Investing in Bonds: Part 1, Types of Bonds: The Cheat Sheet, What is the Federal Funds Rate?, Why Bond Mutual Funds May be Risky Here
