Investments are affected by different types of risk. While you can't totally eliminate these risks, you can develop strategies to help you manage them. The risks associated with bonds include:
Interest rate risk:
Reinvestment risk:
Inflation risk:
Default and credit risk:
Call risk:
Interest rates and bond prices move in opposite directions. A bond's price will rise in value when interest rates fall and decrease in value when interest rates rise. This occurs because the existing bond's price changes to provide the same return as an equivalent, newly issued bond at prevailing interest rates.
The longer the bond's maturity, the greater the impact of interest rate changes. Also, the effects of interest rate changes on market value tend to be less significant for bonds with higher-coupon interest rates.
To help you manage this risk, consider holding the bond to maturity. This eliminates the impact of interest rate changes, since the total principal value will be paid at maturity. Thus, selecting a maturity date that coincides with your cash needs will help you manage interest rate risk.
However, you may still receive an interest income stream that is lower than current rates. Selecting shorter maturities or using a bond ladder can also help you with this risk.
You typically know what interest income you'll receive from a bond. But you must then take that periodic income and reinvest it, usually at varying interest rates. Your principal may also mature at a time when interest rates are low.
Staggering maturities over a period of time (laddering) can help you lessen reinvestment risk. Since the bonds in your ladder mature every year or so, you reinvest the principal over a period of time instead of in one lump sum.
Since bonds typically pay a fixed amount of interest and principal, the purchasing power of those payments decreases due to inflation, which is a major risk for intermediate- and long-term bonds.
Investing in short-term bonds reduces inflation's impact, since you are frequently reinvesting at prevailing interest rates. You can also consider inflation-indexed securities issued by the U.S. government, which pay a real rate of return above inflation.
Default risk is the risk that the issuer will not be able to pay the interest and/or principal. Credit risk is the risk that the issuer's credit rating will be reduced, which will likely decrease the bond's value.
To help you reduce this risk, consider purchasing U.S. government bonds or bonds with investment-grade ratings. Continue to monitor the credit ratings of bonds purchased.
Call provisions allow bond issuers to replace high-coupon bonds with lower-coupon bonds when interest rates decrease.
U.S. government securities do not have call provisions. However, most corporate and municipal bonds have call provisions. Review the call provisions before purchase to select those most favorable.
Keep in mind that the assumption of risk is generally rewarded with higher return. One of the safest bond strategies is to only purchase three-month Treasury bills, but this typically results in the lowest return. To increase your return, you should decide which risks you are comfortable assuming and devise a corresponding bond strategy.
