Understanding Bond Risk

Like other investments, wWhen you invest in bonds and bond funds, you face investment the risk that you might lose money. In addition, the following risks, which can happen if the price falls and you sell for less than you paid. Just because you take investment risks doesn't mean you can't exert some control over what happens to the money you invest. apply specifically to bonds:

Interest Rate Risk


Let's look at the risks inherent in rising interest rates.


If you need to sell your 4 percent bond prior to maturity you must compete with newer bonds carrying higher coupon rates. These higher coupon rate bonds decrease the appetite for older bonds that pay lower interest. This decreased demand depresses the price of older bonds in the secondary market, which would translate into you receiving a lower price for your bond if you need to sell it. In fact, you may have to sell your bond for less than you paid for it. This is why interest rate risk is also referred to as market risk.



Call Risk

Similar to when a homeowner seeks to refinance a mortgage at a lower rate to save money when loan rates decline, a bond issuer often calls a bond when interest rates drop, allowing the issuer to sell new bonds paying lower interest rates—thus saving the issuer money. For this reason, a bond is often called following interest rate declines. The bond's principal is repaid early, but the investor is left unable to find a similar bond with as attractive a yield. This is known as call risk.

With a callable bond, you might not receive the bond's original coupon rate for the entire term of the bond, and it might be difficult or impossible to find an equivalent investment paying rates as high as the original rate. This is known as reinvestment risk. Additionally, once the call date has been reached, the stream of a callable bond's interest payments is uncertain, and any appreciation in the market value of the bond may not rise above the call price.

Duration Risk



For more information, see FINRA's alert, Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio.

Refunding Risk and Sinking Funds Provisions

A sinking fund provision, which often is a feature included in bonds issued by industrial and utility companies, requires a bond issuer to retire a certain number of bonds periodically. This can be accomplished in a variety of ways, including through purchases in the secondary market or forced purchases directly from bondholders at a predetermined price, referred to as refunding risk.

Holders of bonds subject to sinking funds should understand that they risk having their bonds retired prior to maturity, which raises reinvestment risk.

Default and Credit Risk


While U.S. Treasury securities are generally deemed to be free of default risk, most bonds face a possibility of default. This means that the bond obligor will either be late paying creditors (including you, as a bondholder), pay a negotiated reduced amount or, in worst-case scenarios, be unable to pay at all.

Using Ratings Agencies to Assess Default & Credit Risk

The Securities and Exchange Commission (SEC) has designated 10 rating agencies as Nationally Recognized Statistical Rating Organizations (NRSROs).

These organizations review information about selected issuers, especially financial information, such as the issuer's financial statements, and assign a rating to an issuer's bonds—from AAA (or Aaa) to D (or no rating).

Each NRSRO uses its own ratings definitions and employs its own criteria for rating a given security. It is entirely possible for the same bond to receive a rating that differs, sometimes substantially, from one NRSRO to the next. While it is a good idea to compare a bond's rating across the various NRSROs, not all bonds are rated by every agency, and some bonds are not rated at all. In such cases, you may find it difficult to assess the overall creditworthiness of the issuer of the bond.

Slow Down When You See "High Yield"

Generally, bonds are lumped into two broad categories—investment grade and non-investment grade. Bonds that are rated BBB, bbb, Baa or higher are generally considered investment grade. Bonds that are rated BB, bb, Ba or lower are non-investment grade. Non-investment grade bonds are also referred to as high-yield or junk bonds. Junk bonds typically offer a higher yield than investment-grade bonds, but the higher yield comes with increased risk—specifically, the risk that the bond’s issuer may default.

Don't Reach
Investors who decide which bonds to buy based solely on a bond's yield are "reaching for yield," one of the most common mistakes bond investors make. See FINRA’s Investor Alert The Grass Isn’t Always Greener—Chasing Return in a Challenging Investment Environment.

Inflation and Liquidity Risk





Event Risk

Mergers, acquisitions, leveraged buyouts and major corporate restructurings are all events that put corporate bonds at risk, thus the name event risk.

Other events can also trigger changes in a company's financial health and prospects, which may trigger a change in a bond's rating. These include a federal investigation of possible wrongdoing, the sudden death of a company's chief executive officer or other key manager, or a product recall. Energy prices, foreign investor demand and world events also are triggers for event risk. Event risk is extremely hard to anticipate and may have a dramatic and negative impact on bondholders.