How Much Can You Lose in Bonds?

If interest rates rise, bond investors can lose 30 - 50% even in seemingly safe and conservative government bonds.

Clearly, if an issuer declares bankruptcy, a bondholder stands to lose all or a substantial part of his investment. On the other hand, even the shakiest bond can return the full face value at maturity. I am excluding those two extreme cases as the real danger lies in the middle.

Rising Interest Rates Depress Bond prices

When interest rates go up, bonds go down because most bonds are issued with fixed interest that is expressed as a percentage of face value, or par, at issuance (the coupon rate) but is set in dollars throughout the life of a bond. For example, a 5% coupon 20-year bond will pay $50 in annual interest for each $1,000 or face value until maturity. If interest rates increase, new bonds will be issued with a higher coupon, let's say 6%, meaning that they will pay $60 annually for each $1,000 of face value. The old 5% coupon bond will have to be re-priced at $833 to yield 6%.

When interest rates are low, most bonds trade at a premium to face value. If the prevailing interest rates are 4%, the 5% coupon bond will be priced at $1,250 to yield 4%.

If an investors buys a 5% coupon bond for $1,250 (when it's yielding 4%) and interest rates rise to 6%, his bond will be worth $833 - a whopping 33% loss!

Long Maturities Add Uncertainty and Volatility

At maturity, the investor gets back the full face value, regardless of the interest rates. So the best case scenario for an investor who bought a 5% coupon bond at $1,250 is that he will get back $1,000 - a 25% loss. If the investor has a year or two to wait until maturity, things are not that bad. But what if the bond matures in 20 years? Few investors have the tenacity to hold a losing bond for that long.

Panic Selling May Further Depress Prices

Bond prices are also affected by supply and demand. When investors sell in a panic, supply overwhelms demand, so bond prices drop even more than they should based on the underlying fundamentals - that's how a 30% loss can become a 40% loss.

Bond Funds May Fare Far Worse

Bond funds do not have maturity dates because they constantly buy and sell bonds based largely on investor fund inflows and outflows. When investors are pulling money out of bond fund, the bond fund must sell bonds from its portfolio to cover the redemptions. If it sells a bond at a loss, that loss becomes permanent because the fund no longer has the bond and can't get its full face value at maturity.

Fierce competition among bond funds forces them to take additional risks to boost yield in order to attract investors. The risk can take many forms such as leverage, lower quality bonds or derivatives trading. These practices are usually buried deep inside a prospectus. As long as investors are making money in a fund, they don't care how the manager does it, so they rarely check. These practices can boost returns but can also exacerbate losses if the fund manager makes the wrong bet or the market moves against him.

So can an investor lose up to 50% in a long-term government bond fund? Possibly, under certain circumstances. Doesn't mean that he will but it is always prudent to compare the potential upside and downside when considering or re-evaluating an investment.