Bonds can be a great tool to generate income and are widely considered to be a safe investment, especially when compared to stocks. However, investors need to be aware of some potential pitfalls and risks to holding corporate and/or government bonds. In this article, we'll expose the risks that wait to steal your hard-earned profits.

1. Interest Rate Risk

Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends to fall. This happens because when interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will scoop up existing bonds that pay a higher interest rate than the prevailing market rate. This increase in demand translates into an increase in bond price. On the flip side, if the prevailing interest rate were on the rise, investors would naturally jettison bonds that pay lower interest rates. This would force bond prices down.

Let's look at an example:

Example - Interest Rates and Bond Price

An investor owns a bond that trades at par value and carries a 4% yield. Suppose the prevailing market interest rate surges to 5%. What will happen? Investors will want to sell the 4% bonds in favor of bonds that return 5%, which in turn forces the 4% bonds' price below par.

2. Reinvestment Risk

Another danger that bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.

The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value.

However, the downside to a bond call is that the investor is then left with a pile of cash that he or she may not be able to reinvest at a comparable rate. This reinvestment risk can have a major adverse impact on an individual's investment returns over time.

To compensate for this risk, investors receive a higher yield on the bond than they would on a similar bond that isn't callable. Active bond investors can attempt to mitigate reinvestment risk in their portfolios by staggering the potential call dates of their differing bonds. This limits the chance that many bonds will be called at once.

3. Inflation Risk

When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held.

But what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation).

Put another way, suppose that an investor earns a rate of return of 3% on a bond. If inflation grows to 4% after the bond purchase, the investor's true rate of return (because of the decrease in purchasing power) is -1%.

4. Credit/Default Risk

When an investor purchases a bond, he or she is actually purchasing a certificate of debt. Simply put, this is borrowed money that must be repaid by the company over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government, but instead depend on the corporation's ability to repay that debt.

Investors must consider the possibility of default and factor this risk into their investment decision. As one means of analyzing the possibility of default, some analysts and investors will determine a company's coverage ratio before initiating an investment. They will analyze the corporation's income and cash flow statements, determine its operating income and cash flow, and then weigh that against its debt service expense. The theory is the greater the coverage (or operating income and cash flow) in proportion to the debt service expenses, the safer the investment.

5. Rating Downgrades

A company's ability to operate and repay its debt (and individual debt) issues is frequently evaluated by major ratings institutions such as Standard & Poor's or Moody's. Ratings range from 'AAA' for high credit quality investments to 'D' for bonds in default. The decisions made and judgments passed by these agencies carry a lot of weight with investors.

If a company's credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will take notice and may charge the company a higher interest rate for future loans. This can have an adverse impact on the company's ability to satisfy its debts with current bondholders and will hurt existing bondholders who might have been looking to unload their positions.

6. Liquidity Risk

While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond.

Low interest in a particular bond issue can lead to substantial price volatility and possibly have an adverse impact on a bondholder's total return (upon sale). Much like stocks that trade in a thin market, you may be forced to take a much lower price than expected to sell your position in the bond.

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