Top 8 Ways Lose Money On Bonds

[junkman]

"Top 8 Ways Lose Money On Bonds" is the title of an article at Investopeda, always a good source of information and opinion on matters financial. The whole article can be read by clicking on the link below. But here’s an excerpt relevant to an ongoing discussion.
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3. Inflation-Indexed Bonds Or TIPS
Here's one [way to lose money] that not so many investors are familiar with. Treasury inflation protected securities (http://www.investopedia.com/terms/t/tips.asp) (TIPS) (called "real return bonds" for Canadian investors) are supposed to be the answer to that inflation issue. Unfortunately, there are still three distinct ways to lose money on these investments.



Deflation: This is not an everyday occurrence but certainly a possibility. Because of the way values on TIPS are calculated, an extended period of deflation (http://www.investopedia.com/terms/d/deflation.asp) could return you less cash on maturity than you originally invested. Your purchasing power (http://www.investopedia.com/terms/p/purchasingpower.asp) might be intact, but you would emerge with less than a regular bond would have paid you. (To learn more about deflation, read What does deflation mean to investors? (http://www.investopedia.com/ask/answers/202.asp))
Consumer Price Index: Changes in the calculation of the Consumer Price Index (http://www.investopedia.com/terms/c/consumerpriceindex.asp) (CPI) could also bring losses. Again, not a daily occurrence, but it has been done and new methods of calculation are regularly being tested and promoted to result in a reduction in your TIPS' value. (Read about the differing opinions on how to calculate inflation in The Consumer Price Index Controversy (http://www.investopedia.com/articles/07/consumerpriceindex.asp).)
Taxation: Finally, TIPS are taxed on both the yield (http://www.investopedia.com/terms/y/yield.asp) and capital-appreciation (http://www.investopedia.com/terms/c/capitalappreciation.asp) (CPI-linked) portions of the bond. It's quite possible that high bouts of inflation would trigger significant tax bills that would render the bond's real yield lower than the rate of inflation. Tax-sheltered (http://www.investopedia.com/terms/t/taxshelter.asp) accounts are therefore best for holding these instruments. (Tax Tips For The Individual Investor (http://www.investopedia.com/articles/01/112801.asp) can help you keep more of your money in your pocket.)

So, it's not just me who is saying that these things can be dangerous and toxic, unless, of course, your intention is to lose money. ROTFL


Read more: http://www.investopedia.com/articles/bonds/08/lose-money-bonds-losses.asp#ixzz2DGcUaFjx (http://www.investopedia.com/articles/bonds/08/lose-money-bonds-losses.asp#ixzz2DGcUaFjx)

[try2bfrugal]

There are pros and cons to every investment, and not every investment will do well under all economic conditions. That is why asset allocation is popular. TIPS and I bonds are usually good bets as hedges against inflation compared to fixed rate bonds.
(http://money.usnews.com/money/blogs/the-best-life/2009/04/24/5-tips-for-investing-in-tips-treasury-inflation-protected-securities)

[junkman]

There are pros and cons to every investment, and not every investment will do well under all economic conditions. That is why asset allocation is popular. TIPS and I bonds are usually good bets as hedges against inflation compared to fixed rate bonds.
(http://money.usnews.com/money/blogs/the-best-life/2009/04/24/5-tips-for-investing-in-tips-treasury-inflation-protected-securities)

The best hedge against 'inflation' is a rate of return that is multiples of the inflation-rate. TIPS and I-Bonds are derivatives based on the CPI, which under-reports inflation as most people experience it. How big is the discrepancy? Probably something in the range of 3% to 5%.

Again, the curretn I-Bond offers a 0% interest-rate and a 1.76% inflation adjustment rate. Pay ordinary-income taxes on total interest, and an investor is left with a spendable return of 1.32%. But since his or her personally-experienced rate of inflation is probably running at 5% to 6%, he or she has suffered a loss of (3.68%) to (4.68%). Ouch! That hurts. Choosing to lose money isn't investing. It is merely gambling. As long as the would-be investor has chosen to gamble, why not pick a game that offers far better payoffs?

[try2bfrugal]

I think most people buying TIPS and I bonds right now are concerned about the potential for high inflation. Two percent 30 Year TIPS under 10% inflation would return 12% annually, while 5% fixed coupon bonds bought at par would return 5%, or -5% under inflation.

Under deflation the fixed rate bonds would do better, but with current government debt levels in the U.S. being what they are, most long term investors are placing higher odds on future inflation.

[junkman]

When asked whether he expects 'deflation' or 'inflation' to lie ahead of us, John Mauldin replies, "Yes", and he follows up by saying that we will have both and outlines the conditions each might occur. What will actually happen is a whole 'nother story and anyone's guess.

If a small investor (meaning, an unaccredited investor) is buying TIPS to hedge against the possibility of high inflation, is that really the most effective play they could be making? That's what I question, and I'm willing to bet against its effectiveness. Time will tell which of us is right.

[try2bfrugal]

Many TIPS have had a cumulative return of over 50% these last few years, if you add in price increases, due to the drop in interest rates. I think for the time required to manage and research they are a good deal, but your mileage may differ. The only time I spend any time on them is I mark down when the next auctions are coming up and put in an online order a few days before, to dollar cost average the yields and build something close to a ladder. If I spent 1,000 hours a year researching other kinds of bonds, then I would be subtracting from my work income and I wouldn't come out ahead money-wise if I cut my regular income in half. So for me I think having a percent of our retirement fund in TIPS are a good "play" from a safety, rate, inflation hedge and time management point of view.

[junkman]

Try2b,

Yes, any long-dated bond that is almost a pure play on interest-raters has done well over the past several years, not just TIPS, because they've benefited from declining interest-rates. But when you compared all of those plays against each other, those that are the purest play --zeros -- have done the best. The insurance function --the embedded option-- in TIPS and I-bonds comes at a price that distracts from performance. But how you are averaging into them is reasonable and efficient. Go for it.

Charlie

[freein05]

There is another way to lose money on so called A rated bonds. If you are interested I have some Lehman and Washington Mutual bonds I am willing to sale at a deep deep discount.rrrrr

[junkman]

Free,

Any issuer can default --or can be forced to-- which is what happened with Lehmans. Arbitrarily, they were let to go under, and other, equally-insolvent banks were bailed out. Losses are part of any securities game, and they aren't restricted to bonds. Take the loss and move on.

Charlie