Bond Risks

Treasuries

Interest Rate Risk

Although Treasuries have no credit risk, they are subject to interest rate risk, just like all other bonds. The underlying value of the bond may change depending on the movement of interest rates. When interest rates rise, bond prices fall, and vice versa. As long as the investor is planning to hold his Treasury until maturity, he can ignore changes in market value of the bonds. However, if the investor sells before maturity, at any given time the bond could be worth more or less than he paid for it.

Inflation Risk

This is the risk that rising interest rates will cause bond prices to fall. Bonds with long-term maturities, low coupon rates and deep discount bonds are the most susceptible to this risk.

Purchasing Power Risk

If the interest being earned on a bond falls below the inflation rate, you could lose purchasing power.

Corporate Bonds

Corporate Default Risk

This represents the risk that the issuing corporation will fail to pay the interest and/or repay the principal at the time it is due. One tool used to approximate the risk of default for a particular bond is the ratings done by independent companies. Investment-grade bonds are represented by ratings of Baa3/BBB- to Aaa/AAA, while high yield or less-than-investment-grade bonds are represented by ratings of Ba/BB+ or lower. For a brief description, see the ratings chart in the Ratings section.

Market Risk

The value of corporate and agency bonds will move up and down based on the current interest rates, anticipated interest rates and supply and demand. If you decide to liquidate your corporate bond prior to maturity, you will be entitled to receive the current market price based on the current market conditions. When rates move up, prices move down, and vice versa. At any given time, your bond could be worth more, less or about the same price you paid for it.

Liquidity Risk

The ability to easily sell and convert your bond into cash will be determined by how active a secondary market exists for your bond. In general, for a bond to enjoy high marketability, there must be a large trading volume and a large number of dealers in the security.

Call Risk

This is a situation where the issuer will redeem the bond prior to the stated maturity. Associated with the call risk are corporate bonds subject to sinking fund provisions or 'extraordinary redemption' calls. These provisions allow the corporation to retire a portion of their dept early. Bonds that are callable could see their yields dramatically affected.

Inflation Risk

A rise in the inflation rate can result in the loss of future purchasing power.

Reinvestment Risk

All bonds with coupons have reinvestment risk. The yield to maturity (YTM) on a bond implies that the interest (coupon rate) is reinvested at the YTM rate. If interest rates decline, this reinvestment risk becomes greater.

Munis

Default Risk

This represents the risk that the issuing municipality will fail to pay the interest and/or repay the principal at the time it is due. One tool used to approximate the risk of default for a particular bond is the ratings done by independent companies. Investment-grade bonds are represented by ratings of Baa/BBB to AAA, while high yield or less-than-investment-grade bonds are represented by ratings of Ba/BB or lower. For a brief description, see the ratings chart.

Market Risk

The value of a muni bond will move up and down based on the current interest rates, anticipated interest rates and supply and demand. If you decide to liquidate your bond prior to maturity, you will be entitled to receive the current market price based on the current market conditions. When rates move up, prices move down and vice versa. At any given time, your bond could be worth more, less or about the same price you paid for it.

Liquidity

The ability to easily sell and convert your bond into cash will be determined by how active a secondary market exists for your bond. In general, for a bond to enjoy high marketability, there must be a large trading volume and a large number of dealers in the security.

Call Risk

This is a situation where the issuer will redeem the bond prior to the stated maturity. Associated with the call risk are bonds subject to sinking fund provisions. These provisions allow the corporation to retire a portion of their dept early. Muni bonds that are not able to be held until maturity could see their yields dramatically affected. Some types of munis are callable at any time at 100 cents on the dollar. Some have extraordinary calls that enable the issuer to call the issue early even if the issue is non-callable.