Bonds can be a great tool to generate income and are widely considered to be a safe investment, especially compared with stocks. However, investors should be aware of the potential pitfalls to holding corporate bonds and government bonds. Below, we'll discuss the risks that could impact your hard-earned returns.

1. Interest Rate Risk and Bond Prices

The first thing a bond buyer should understand is the inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices tend 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 prices.

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

2. Reinvestment Risk and Callable Bonds

Another danger bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than what 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 the investor is then left with a pile of cash they might not be able to reinvest at a comparable rate. This reinvestment risk can adversely impact 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 differing bonds. This limits the chance that many bonds will be called at once.

3. Inflation Risk and Bond Duration

When an investor buys a bond, they essentially commit 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 this happens, investors will see their purchasing power erode, and they may actually achieve a negative rate of return when factoring in inflation.

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

4. Credit/Default Risk of Bonds

When an investor purchases a bond, they are actually purchasing a certificate of debt. Simply put, this is borrowed money the company must repay 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 issuer'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 company'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 of Bonds

A company's ability to operate and repay its debt issues is frequently evaluated by major ratings institutions such as Standard & Poor's Ratings Services or Moody's Investors Service. 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 an issuer's corporate credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will take notice and may charge a higher interest rate for future loans. This can adversely impact the company's ability to satisfy its debts and hurt existing bondholders who might have been looking to unload their positions.

6. Liquidity Risk of Bonds

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

Low buying interest in a particular bond issue can lead to substantial price volatility and adversely impact a bondholder's total return upon sale. Much like stocks that trade in a thin market, you may be forced to take a far lower price than expected when selling your position in the bond.