Bond Risks

Bonds carry several key risks that can impact their value and returns. Here’s a breakdown of the main risks:

1. Interest Rate Risk

   • Definition: This is the risk that bond prices will fall due to rising interest rates. When interest rates go up, new bonds are issued with higher yields, making existing bonds with lower rates less attractive.
   • Impact: Longer-maturity bonds are especially vulnerable because their lower rates are locked in for a longer period.

2. Credit (Default) Risk

   • Definition: The risk that the bond issuer may be unable to make interest payments or repay the principal.
   • Impact: Higher-rated (investment-grade) bonds have lower credit risk, while lower-rated (high-yield or “junk”) bonds have higher risk but potentially offer higher returns.

3. Inflation Risk

   • Definition: The risk that inflation will reduce the purchasing power of a bond’s fixed payments.
   • Impact: Inflation can erode real returns, particularly on long-term bonds with fixed interest payments, as it reduces the future value of these payments.

4. Liquidity Risk

   • Definition: This is the risk of not being able to sell a bond easily without affecting its price.
   • Impact: Some bonds, like government bonds, are highly liquid, while others, such as corporate or municipal bonds, may have fewer buyers and be harder to sell quickly.

5. Reinvestment Risk

   • Definition: The risk that the proceeds from a bond (interest payments or principal repayment) may have to be reinvested at a lower rate if interest rates fall.
   • Impact: Bonds with frequent coupon payments and callable bonds (which can be redeemed by the issuer before maturity) are particularly susceptible.

6. Call Risk

   • Definition: The risk that a bond issuer may “call” or repay the bond before maturity, usually when interest rates fall.
   • Impact: Investors may lose out on future interest payments, which would have been higher than the current market rate.

7. Currency Risk

   • Definition: This affects bonds issued in a foreign currency. Currency fluctuations can impact the return when converted back into the investor’s home currency.
   • Impact: Currency risk is relevant for investors in international or emerging market bonds, as exchange rate changes can affect total returns.

Understanding these risks can help investors build bond portfolios that align with their risk tolerance, financial goals, and market expectations.