Bonds are usually hailed as "safe." When you buy a bond, you are actually lending money to an entity -- the U.S. government, say, or a municipality or company -- for a set period of time at a fixed rate of interest. At the end of the term, the borrower must repay the obligation in full.
Yet bond investors face a number of risks. Here are a few to understand.
Interest rate risk: Interest rates can affect bond prices. If you hear that interest rates are on the rise, you can count on your individual bond or bond mutual fund dropping in value. Here's how it works: If you own a 10-year U.S. government bond that is paying 5%, it will be worth more now, when new bonds issued by Uncle Sam are only paying about 2.2%. Conversely, if your bond is paying 2% and your friend can purchase a new bond paying 5%, nobody will be interested in your bond and the price will fall. (That's why bond prices move in the opposite direction of prevailing rates, regardless of the bond type.)
Credit risk: This is the risk of default or that the entity does not pay you back at the end of the term. That is a pretty low risk if the entity is the U.S. government, but can be a high one if the bond was issued by a company, city or government entity that is in trouble -- for an example, think about the problems that Detroit and Puerto Rico have had, or consider a small energy company that needs oil to trade at $50 to make loan repayments.
Inflation risk: Even if the bonds are paid in full, the amount paid out can be worth less over time, due to inflation. A sudden spike in inflation would eat into the fixed stream of payments that bonds provide.
Why Risk Matters
Because bonds deliver a consistent stream of income, many investors view them as the perfect retirement vehicle. But as mentioned above, bond prices can fluctuate. The worst calendar year for the broad bond market was 1994, when returns were negative 2.9%, due to an unexpected upward shift in interest rates. (Prices actually dropped even more that year, but the interest payments helped defray some of the bonds' losses).
So you can in fact lose money in the bond market, although the magnitude of the fluctuations tends to be smaller than those in stocks and other riskier asset classes.
Chances are that rates will rise in the coming months and years. That does not mean that you should avoid bonds altogether, but you may want to be careful about the types of bonds that you put inside your portfolio. If you're not just using a broad based bond index fund, stick to shorter-duration and higher-quality bonds, which can still have a stabilizing effect on a diversified portfolio over time.