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Bonds Risk vs. Return The return and the risk of a bond is determined by several factors. Here are some factors that determine how safe or how risky a bond may be. High quality vs. low quality bonds Short-term vs. long-term bonds Interest rates and bonds How different bonds have performed Major risk High quality vs. low quality bonds The quality of a bond is determined by the ability of the issuer to pay the bond off on time. Government bonds, some municipal bonds and bonds offered by large, financially solvent corporations are generally considered to be higher in quality, lower in risk. Bonds that are issued by corporations, agencies or local government units that are not as financially solvent are considered low quality, "high yield" bonds. Their yields are higher because there is more risk connected with these instruments. Investing in higher-yielding, lower rated bonds has an increased risk of price fluctuations and loss of principal. Bonds, like people, have credit ratings. The difference is that bond ratings are made public and can be checked by anyone. Most widely traded bonds are rated by at least one of the major agencies in the field, Moody's Investors Services and Standard & Poor's Corp.   Quick Question What's another name for a high-quality bond? A. Agency bond B. Investment-grade bond C. Local-government bond D. Junk bond   Quick Question What's another name for a low-quality bond? A. Municipal bond B. Mortgage-backed security bond C. Government bond D. Junk bond Short-term vs. long-term bonds The amount that bonds fluctuate also depends on the term of the bond. Generally, the shorter the maturity, the more stable the value of a bond. While the value of a bond fluctuates, you will only notice the price changes if you need to sell your bond prior to maturity at which point you will receive the current market value of the bond. If you hold the bond until maturity, you receive the full amount of the bond — the face amount. Interest rates and bonds Another risk in bond investing is interest rate risk. The value of a bond fluctuates on a daily basis in the opposite direction to interest rates. When interest rates go up, typically the value of a bond will go down. When interest rates go down, typically the value of a bond will go up. The above example on interest rate risk oversimplifies the relationship between bond values and fluctuating interest rates since actual market prices are also influenced by the time remaining to the bond's maturity or possible call time. However, the underlying principal is the same: As interest rates rise, bond prices fall. As interest rates fall, bond prices rise.   Quick Question How much will Jeff's $1,000 bond drop in value if interest rates go up 1%? Jeff just purchased a $1,000 bond with a coupon interest rate of 6% - $60 a year. A year later, interest rates have risen to 7%. If Jeff wants to sell his bond which is paying him $60 a year, he must offer it at a price which will deliver a 7% current yield to the buyer. Otherwise a new buyer would have no incentive to purchase Jeff's 6% bond in a market that's paying 7%. A. $1,000 = 7% of $857 so the price of the bond is now approximately $857. B. $60 = 7% of $857 so the price of the bond is now approximately $857. C. $60 = 7% of $1,000 so the price of the bond is now approximately $1,000. D. $60 = 6% of $857 so the price of the bond is now approximately $857. How different bonds have performed Again, modern portfolio theory holds true for bond investing. While the results are not as dramatic as with the stock example — because bonds are generally less volatile than stocks — you can still see periods where the performance of one type of bond is going up while another is going down. High-yield bonds involve a greater possibility that adverse changes in the economy or poor performance by their issuers may affect their ability to pay principal and interest. Corporate, government and municipal bonds fluctuate in value; unlike many government bonds, corporate bonds are not guaranteed. International bonds involve special risks, including currency fluctuations, economic instability and political developments. Unlike other bonds, CDs are insured up to $100,000 per account per institution. Major risk When you invest, you need to be aware of the major risks. Let's look at some. Call risk Many bond issuers reserve the right to redeem or "call" their bonds before they mature. When they do this, they only have to pay the bondholder par value. This usually happens when interest rates fall and the investor not only gets less than market price on the bond, but also has to find a place to reinvest the money. Capital risk Your capital may not be returned to you intact. Stocks generally represent a greater capital risk than do bonds. Credit risk The risk that a bond issuer will be unable to meet payments of interest and/or principal. Inflation risk The danger that rising prices will reduce the purchasing power of an investment. Market risk The risk that a drop in the stock or bond markets will hurt your investment, and you will lose money as a result. Economic risk The risk that overall slower economic growth will cause investments to fall in price. Specific risk These are risks such as poor management or a business setback that might affect only a specific company or industry. < PREVIOUS NEXT > #40044