If you are a professional money manager, then you should already know the answer to this question. Meanwhile, if you are a beginning investor, you probably believe that bond funds are safe. Well, we have bad news for you. Unfortunately, that is not precisely the case.
Nowadays, believing bond funds are safe is a common misconception. Moreover, inexperienced investors often presume bond funds cannot depreciate in value. However, the truth is that they can. But how can you lose money with bond funds?
Well, in this article we will give you the answer to this question. Not only this, but we will also share with you ideas on how you can minimize the losses. So, if you want to learn how to profit even when most bond funds are losing, then keep on reading.
What are Bond Funds?
Bond funds are pooled investments in bonds of varying maturities and other debt instruments. In other words, they consist of many holdings — for example, government bonds, corporate bonds, mortgage-backed securities, etc. Generally, the goal of all bond funds is to generate monthly income for all investors.
Also, this is one of the reasons why investors love bond funds. Typically, bond fund managers often, if not consistently, trade the underlying bonds held in the fund. Further, bond funds offer instant diversification for all investors. The best part is that they don’t require huge investment capital.
Furthermore, in this article, we won’t go into detail about what bond funds are. Moreover, we will only briefly explain what they are. So, if you want to learn more about bonds, bond funds, then you should read The Basics of Bonds
Nowadays, experienced investors prefer bond funds instead of bonds due to the liquidity and diversification offered by bond funds. But what should investors do when the value of bond funds declines in value? Typically, bond prices and interest rates move in the opposite direction.
Currently, many beginning investors lack the experience of professional investors. Most of them probably wonder whether they can lose money with bond funds, or are they a safe investment choice?
Why Bonds Decline in Value?
As an investor, you should already know that, like stocks value, the value of bonds can depreciate or appreciate. Moreover, when the price of the bonds you have invested in appreciates in value, you could profit from the difference. Of course, that is if you decide to sell them.
However, when the opposite happens, and the price depreciates in value, then you might lose money if you decide you want to sell the bonds. In this case, you won’t lose any money until you sell the bonds. But if you choose to sell it before maturity, then you will be selling the bonds at a lower price. Also, by doing so, you will be accepting the loss.
Moreover, it is essential to note that bond funds don’t’ have a price. They are valued by the Net Asset Value, which is also the key to gaining or losing capital.
Furthermore, bond funds are associated mainly with two kinds of risks – interest rate risk and credit risk. Generally, if the interest rates rise, the bond price will decrease. Likewise, if the market expects the interest rate to fall, then the bond price will increase. Typically, the higher the duration, the more vulnerable to interest rate changes the bond is.
Interest Rate Risk
Interest Rate Risk = the risk that an asset’s value will alter as a consequence of interest rate volatility. IRR is the potential loss from unexpected changes.
Time has shown that the correlation between interest rates and bond prices may be confusing to most investors. Some inexperienced investors even believe that holding a bond to maturity makes their portfolio somehow immune to interest rate risk.
Typically, a bond’s coupon is determined at issuance. So, say the market expects the interest rate to rise and it does. Then the total expected return when you decide to hold the bond to maturity will be equal to the total expected return if you choose to sell at a loss and buy another bond with a higher coupon.
Other Risks of Investing in Bond Funds
- Credit Risk = the risk that a bond issuer may fail to make the required payment on time.
- Inflation Risk ( Purchasing Power Risk ) = the risk that the cash flow from an investment won’t be worth as much in the future due to inflation
- Reinvestment Risk = the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being that there might not be a similarly attractive investment available.
- Liquidity Risk = risk that for a certain period, a given financial asset, security, or commodity cannot be traded quickly enough in the market without impacting the market price.
Can You Lose Money With Bond Funds?
Well, the answer to this question is both yes and no. It all depends on the experience you have. For example, experienced investors know that a long-term bond has a higher interest rate risk than a short-term bond. Also, they know that the longer the maturity, the larger the swing in price. This means that long-term bonds are quickly and significantly affected by changes in interest rates. Which, on the other hand, impacts the amount of monthly interest income.
Moreover, typically, when interest rates are rising, bond prices are decreasing. When the market is expecting the interest rate to rise, some investors might see this as an excellent opportunity to buy shorter maturities. On the other hand, when the opposite is predicted ( interest rates are expected to decline), other investors prefer to buy longer maturities.
So, let’s get to the most crucial question. Can you lose money with bond funds? As the price of a bond fund can fluctuate if you decide to sell when interest rates are rising, the bond fund might lose value.
Bond funds are an excellent way for beginning investors to create a diversified portfolio. Also, as they are more comfortable for investors to participate in, many investors prefer them. Moreover, as we mentioned above, bond funds are valued by their Net Asset Value, which may result in a capital gain or loss.
And, as their price is volatile, the decisions you take are crucial, especially when the value decreases. So, whether you will make or lose money with bond funds depends entirely on your investment strategy, your ability to control your emotions, your knowledge, and your experience.