A:

The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates rise. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. Should the market interest rate rise from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond.

Market interest rates are a function of several factors such as the demand for, and supply of, money in the economy, the inflation rate, the stage that the business cycle is in as well as the government's monetary and fiscal policies. However, interest rate risk is not the only risk of investing in bonds; fixed-income investments pose four additional types of risk for investors:

Reinvestment Risk

The risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.


Call Risk
The risk that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs.

Default Risk
The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all. Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small, emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investment.

Inflation Risk
The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond and then inflation rises to 10% a year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.

For further reading, see What Is A Corporate Credit Rating?, Call Features: Don't Get Caught Off Guard and our Bond Basics Tutorial.

RELATED FAQS
  1. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
  2. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  3. Do long-term bonds have a greater interest rate risk than short-term bonds?

    There is a greater probability that interest rates will rise within a longer time period than within a shorter period. One ... Read Answer >>
  4. What is affected by the interest rate risk?

    Find out more about interest rate risk, how bond prices are affected by interest rate fluctuations and how interest rate ... Read Answer >>
Related Articles
  1. Investing

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  2. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  3. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  4. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  5. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  6. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  7. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
RELATED TERMS
  1. Bond

    A debt investment in which an investor loans money to an entity ...
  2. Call Risk

    The risk, faced by a holder of a callable bond, that a bond issuer ...
  3. American Callable Bond

    A bond that can be redeemed by the issuer at any time prior to ...
  4. Call Provision

    A provision on a bond or other fixed-income instrument that allows ...
  5. Bond Resolution

    1. A document used with government bonds, especially general ...
  6. Corporate Bond

    A debt security issued by a corporation and sold to investors. ...
Hot Definitions
  1. Investing

    The act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit.
  2. Stagflation

    A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, ...
  3. Notional Value

    The total value of a leveraged position's assets. This term is commonly used in the options, futures and currency markets ...
  4. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  6. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
Trading Center