A:

The biggest risks of bonds and other fixed-income investments are interest rate risk, credit risk and inflation risk. There are other risks to bear in mind, such as the call risk, but they only apply in a limited number of situations.

As a rule, bond prices and interest rates move inversely from each other. Bond prices usually fall when interest rates rise, because new bonds with higher coupon rates are typically issued if interest rates are higher. For example, if an investor buys a bond with a 3% coupon rate when market interest rates are 3%, and tries to sell it when market interest rates rise to 4%, he gets a lower price than he would have gotten if interest rates did not rise.

Since bonds are a form of debt, the bondholder is exposed to the risk of the debtor defaulting. Moody’s, Standard & Poor and other bond-rating agencies publish ratings that assess the likelihood of default for individual bonds on the market. There are two main divisions: investment grade and non-investment grade. Non-investment grade bonds carry much higher credit risk, but they usually have higher yield to compensate.

Inflation can be particularly harmful to investors in fixed-income securities because their yield is a fixed amount. In case of inflation, the real value of this amount falls and investors may even lose money on a fixed-income investment. The easiest way to deal with inflation risk is to invest in U.S. Treasury Inflation-Protected bonds (TIPS). The principal of these bonds is adjusted for inflation when it is paid out to the bondholder.

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