Bond investing risks

Here are the major risks that can affect your bond's return:

Inflation risk: Since bond interest payments are fixed, their value can be eroded by inflation. The longer the term of the bond, the higher the inflation risk. On the other hand, bonds are a classic deflation hedge; deflation increases the value of the dollars that bond investors get paid.

Interest rate risk: Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall because new bonds are issued that pay higher coupons, making the older, lower-yielding bonds less attractive. Conversely, bond prices rise when interest rates fall because the higher payouts on the old bonds look more attractive relative to the lower rates offered on newer ones.

The longer the term of the bond, the greater the price fluctuation -- or volatility -- that results from any change in interest rates.

There is a close connection between inflation risk and interest rate risk since interest rates tend to rise along with inflation. Interest rate shifts are also a concern for mortgage-backed bondholders, but for a different reason: If interest rates fall, home owners may decide to prepay their existing mortgages and take out new ones at the lower rates.

That doesn't mean you'll lose your principal if you hold such a bond. But it does mean you get your principal back much sooner than expected, forcing you to reinvest it at the newly lower rates. For that reason, the prices of mortgage-backed securities don't get as big a boost from falling rates as other kinds of bonds.

Note that price fluctuations only matter if you intend to sell a bond before maturity, or you invest in a bond fund whose manager trades regularly. If you hold a bond to its maturity, you will be repaid the bond's full face value.

Call risk: Many corporate and muni bond issuers reserve the right to redeem, or "call," their bonds before they mature, at which point the issuer is required to pay bondholders only par value. Typically, this happens if interest rates fall and the issuer sees it can lower its costs by selling new bonds with lower yields.

If you happen to own one of the called bonds, not only do you get less than the market price of the bond, but you also have to find a place to reinvest the money. Because of the risk that you won't get the income you expect, callable bonds usually pay a higher rate of interest than comparable, noncallable bonds. So, when you buy bonds, make sure to ask not only about the time to maturity, but also about the time to a likely call.

Credit risk: This is the risk that your bond issuer will be unable to make its payments on time -- or at all -- and it depends on the type of bond you own and the borrower's financial health. U.S. Treasuries are considered to have virtually no credit risk, junk bonds the highest.

Bond rating agencies such as Standard & Poor's and Moody's evaluate corporations and municipalities for their credit worthiness. Bonds from the strongest issuers are rated triple-A. Junk bonds are rated Ba and lower from Moody's, or BB and lower from S&P.

The highest-quality municipal bonds are backed by bond insurance companies, but there is a trade-off: Insured munis typically yield up to 0.3% points less than comparable uninsured munis. Further, the insurance only guarantees your interest and principal; it won't shield you against interest rate or market risk.

Some higher-coupon munis are also "pre-refunded," meaning that, for esoteric reasons, they are effectively backed by U.S. Treasuries. When a muni is pre-refunded by an issuer, its credit quality and price rise.

Liquidity risk: In general, bonds aren't nearly as liquid as stocks because investors tend to buy and hold bonds rather than trade them. While there is always a ready market for super-safe Treasuries, the markets for other bonds, especially munis and junk bonds, can be highly illiquid. If you are forced to unload a thinly-traded bond, you will probably get a low price.

Market risk: As with most other investments, bonds follow the laws of supply and demand. The more popular or less plentiful a bond, the higher the price it commands in the market. During economic meltdowns in Asia and Russia, for example, the price of safe-haven U.S. Treasuries rose dramatically.

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