A bond is a security that is a debt.

-         The lender is the person who holds the bond.

-         The borrower is the issuer of the bond.

-         The interest paid on the loan (or bond) is the coupon.

Bonds differ from stocks. While stock holders own a share of a company, bond holders are lending money to the company issuing the bond. Bonds also have a term with an end. At the end of the term (also called maturity), the bond is redeemed.

All investments come with their own risks. Bonds are no exception. While bonds provide certain benefits (stability, tax-exempt interest in some cases, and consistent income), the risks of bonds may outweigh the benefits, depending upon your investment objectives.

The Price of a Bond May Fall When Interest Rates Rise

A bond’s interest rate is fixed when it is issued. If market interest rates begin to rise, the bond’s fixed rate will become unattractive.

When fixed bond rates lag behind general interest rates, these bonds become less desirable in the secondary market. The secondary market refers to transactions where – in this case – a bond is purchased by an investor from an investor instead of being purchased from the original issuer. Because of this, you may want to avoid investing in long term bonds during periods of low market interest rates.

For more on interest rate risks when purchasing bonds, visit The Securities Industry and Financial Markets Association. 

The Bond Issuer May Default on the Original Debt

The possibility of a bond issuer defaulting is also known as credit risk. This means that you (the bond holder) could lose all or part of your original investment.

However, some types of bonds have a low credit risk.

-        Government bonds, for example, are considered a safe investment and highly unlikely to default.

-         Municipal bonds and corporate bonds have a higher risk of default than government bonds. However, municipal bonds are often a safe investment. Corporate bond risk varies. The risk depends upon the strength of the company. The more financially unstable a company is, the higher the bond risk.

The interest rates on bonds reflect the level of risk for each type of bond.

-         Federal government bonds have the lowest risk and relatively low interest rates.

-       Municipal bonds are relatively riskier than federal government bonds and have a relatively higher interest rate.

-       Corporate bonds are the most risky of all the bond types and pay the highest interest rates. Extremely risky corporate bonds are sometimes called junk bonds, while less risky corporate bonds are called blue chip bonds.

A bond rating system rates all bonds in terms of risk. The designation “AAA” is given to bonds with the least risk. The ratings range from “AAA” to “D,” with the “D” rating denoting bonds in default. Ratings are given out by independent ratings services including Standard & Poor’s, Moody’s, and Fitch.

For example, Standard & Poor’s ratings for the credit risk of bonds are denoted as follows:

-         AAA and AA: high credit quality

-         AA and BBB: medium credit quality

-       BB, B, CCC, CC, and C: low credit quality

-        D: bonds that have defaulted and cannot pay principal or interest

For more on bond ratings, visit Standard & Poor’s or Moody’s.

Bonds Can Be Called by the Issuer

During the life of the bond, the issuer may decide to call the bonds. This means that the bond holder would need to redeem the bond prior to maturity. The issuer may take this action to reissue bonds at a lower interest rate.

The downside of bonds being called for the bond holder are:

-       You may be forced to reinvest your principal earlier than you anticipated.

-        The interest rates on your reinvested principal may be lower than your original investment.

Visit www.sec.gov/answers/callablebonds.htm for the Securities and Exchange Commission’s (SEC) further explanation of callable bonds.

Inflation May Devalue the Principal or Interest of Your Bond

The rate of interest on a bond is fixed. Likewise, the principal you will recover when you redeem your bond is fixed. If a bond is held during a period of high or increasing inflation, the value of your interest and principal will be diminished. For more on how inflation impacts bond investments, visit FINRA or CNNMoney.com.

Additional Resources

-       The Securities Industry and Financial Markets Association (SIFMA):  http://www.investinginbonds.com

-        TreasuryDirect Web site:  http://www.savingsbonds.gov

-         CNNMoney.com Web site: http://money.cnn.com/magazines/moneymag/money101/lesson7/index.htm

-        An article on bond risks, and investing in bond funds as an alternative: http://www.southsidetrust.com/library/1%20Growing%20Your%20Wealth_pdf/Bond%20risks%20and%20bond%20funds.pdf