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?

    Bond prices fluctuate with changing market sentiments and economic environments but in a much different way and from different ... Read Full Answer >>
  2. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  3. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  4. Do hedge funds invest in bonds?

    Hedge funds have the freedom to deploy their capital in virtually any manner. They can use leverage, invest in non-publicly ... Read Full Answer >>
  5. Do mutual funds pay dividends or interest?

    Depending on the type of investments included in the portfolio, mutual funds may pay dividends, interest, or both. Types ... Read Full Answer >>
  6. Can mutual funds only hold bonds?

    While some mutual funds include bonds in addition to other asset types, certain funds, aptly named bond funds, hold only ... Read Full Answer >>
Related Articles
  1. Credit & Loans

    A FICO-free Loan? See SoFi's Super Bowl Ad

    Non-bank lender SoFi will air its first TV ad during Super Bowl 50. Here's how it's challenging big banks by providing an alternative approach to loans.
  2. Investing Basics

    The Pros and Cons of Distressed Debt Investing

    Distressed debt investing is suitable for professional investors. Besides heavy risk factors to consider, this investment type can provide a large ROI.
  3. Investing Basics

    How to Get More Yield From Your Investments

    Yield seeking investors can boost the amount of income their investments generate through tweaking their portfolio of stocks and bonds.
  4. Investing Basics

    4 Assumptions That Can Hurt Your Retirement

    Retirement planning is a must, but having a plan that's filled with old and dated assumptions can cause great harm.
  5. Investing

    New Year, New Investing Strategy: Exploring ETFs

    Whether you’re a seasoned investor or new to the markets, you need to learn as much as you can about the present environment and how to navigate it.
  6. Bonds & Fixed Income

    Vanguard Income Based Funds Overview (VOO,VPU)

    Discover the different income funds that Vanguard Investments offer, using either mutual funds or ETFs and stocks, bonds or balanced investment styles.
  7. Bonds & Fixed Income

    3 Risks U.S. Bonds Face in 2016

    Learn about the major risks for the bond market in 2016; interest rate increases, high-yield bond volatility and a flatter yield curve may be issues.
  8. Bonds & Fixed Income

    PIMCO - How It Has Fared Since Its Gross Departure

    Learn about how PIMCO has seen massive outflows of investor capital since Bill Gross left the firm. Read about the recent performance of its bond funds.
  9. Bonds & Fixed Income

    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.
  10. Products and Investments

    Best Income Investing Strategies for Retirees

    The past few years have been tough for retirees seeking income from their investments. Here are some of the best strategies that can help.
RELATED TERMS
  1. Extreme Mortality Bond - EMB

    Investopedia defines extreme mortality bond (EMB).
  2. Debenture

    A type of debt instrument that is not secured by physical assets ...
  3. Credit Rating

    An assessment of the creditworthiness of a borrower in general ...
  4. Par

    Short for "par value," par can refer to bonds, preferred stock, ...
  5. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center