Many people invest in bonds for the relative safety they offer compared to riskier investments such as stocks. But just because some bonds are less risky than stocks doesn’t mean they’re risk-free, and investors should carefully weigh the downsides of investing in bonds.

Here are five ways to lose money investing in bonds. Ask yourself if your fixed income investments are exposed to these kinds 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. This means that when rates rise, bond prices fall, all other things being equal.

Some investors learned that lesson the hard way in 2022, as interest rates left their pandemic lows and rose following the Federal Reserve’s decision to raise rates as part of its effort to reduce the galloping inflation. A Bloomberg index listing US government bonds fell about 11% in 2022 through August 23, while a fund listing long-term corporate bonds plunged more than 20%.

In most cases where bond prices fall, the bond coupon payments have remained 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.

2.Inflation

Inflation is detrimental to almost all investments, and bonds are no exception. What may seem like a satisfying return can quickly be swallowed up by even moderate levels of inflation. A bond yielding 2 or 3% would see virtually all of its return wiped out if inflation settled at the Fed’s long-term target of 2%.

In 2021, with rates still near record lows, legendary investor Warren Buffett warned of the potential for low returns from fixed income assets.

“Bonds aren’t the place to be these days,” Buffett told Berkshire Hathaway shareholders. “Fixed income investors around the world – whether pension funds, insurance companies or retirees – face a bleak future.”

Buffett pointed out that buying a 10-year bond yielding 2% is equivalent to paying 50 times a company’s earnings, a key difference being that the bond’s payments cannot increase. Low-yielding bonds are particularly susceptible to seeing their yield wiped out by inflation, as it doesn’t take much to eat away at their already low yields.

3. Downgrading of grades

Another thing that can cause the price of a bond to fall 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 occur for a number of reasons, but are generally associated with an increased likelihood that the issuer will default on 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 matches their investment goals.

4. Credit default

In the event that a company or government defaults on an interest payment to bondholders, the bond is considered to be in default. This creates significant doubt about the company’s future existence and whether bondholders can expect to be repaid. Sometimes there are short-term reasons for issuer default and a solution can be found, but bond prices are more likely to fall as investors try to recover some of their investment while they can.

5. Lack of liquidity

You may also be forced to incur a loss on a bond investment due to the bond’s lack of liquidity. Although the bond market is larger than the stock market, it can also be less liquid, which means it can be more difficult to sell bonds quickly in the market.

If you need to sell a bond with low trading volume, you may need to take a lower price than you expected in order to find a buyer. Trading bonds with low liquidity can increase the likelihood that you will suffer a loss on your investment.

Are bonds a safe investment during bear markets?

Bonds may provide some diversification benefits during a bear market for equities, but there is no guarantee that they will perform well. Historically, certain bonds, such as US Treasuries, have been considered a safe haven during times of financial and economic hardship, causing their yields to plummet and prices to soar.

But in the 2022 bear market, bonds fell alongside stocks as rising interest rates drove down the value of most financial assets. With bond yields still relatively low, their yields are also negatively impacted by the current high levels of inflation.

At the end of the line

Many investors think bonds are safe, but there are still plenty of ways to lose money investing in bonds. Bonds had 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 of investing in bonds.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are cautioned that past performance of investment products does not guarantee future price appreciation.