Due to the fact that most bond interest payments are fixed, their value can be depleted by inflation. Therefore, the longer the term of the bond, the greater the inflation risk.
Interest Rate Risk
The prices of bonds move in the opposite direction of interest rates. When interest rates rise, prices of outstanding bonds fall. This is because newer bonds will be issued paying higher coupons, making the older, lower-yielding bonds less attractive. On the other hand, when interest rates fall, prices of outstanding bonds will rise.
Duration is a measure of a bond price's interest rate sensitivity. This calculation is the approximate percentage change in the price of a bond or bond portfolio due to a 100 basis point change in yields. For example, a bond with duration of five indicates that it's subject to a price change of 500 basis points for each 100 basis point change in yields. Bonds with higher duration carry more risk and have higher price volatility than bonds with lower duration.
Many corporate and municipal bond issuers have the right to redeem or "call" their bonds before they have matured. When the bond is redeemed, the issuer is required to pay the bond holder the par value of the bond only, which means the bond holder may get less than the market price of the bond, but will also have to reinvest his or her funds at prevailing rates.
Because a bond is a debt instrument, there is a risk that the bond issuer will be unable to make its payments on time, or at all. If a company enters bankruptcy, bondholders will receive any money due before stockholders receive their portion. However, depending on the situation, there are no guarantees the bondholder's investment will be returned at all. To evaluate the credit quality of a bond, investors can look to organizations that rate various corporate bonds, such as Moody's Investors Service and Standard & Poor's. Those bonds rated Baa or above by Moody's and BBB or above by Standard & Poor's are considered investment-grade. Bonds rated below investment grade are considered more speculative and carry greater risk. For a table of Moody's and S&P credit rating categories, click here.
Bonds, in general, do not offer the liquidity that stocks provide. When purchasing a bond, investors need to remember that they generally should be considered a longer-term investment.
Because the rate on most bonds is fixed, the market value of these investments will fluctuate over time, reflecting current changes in interest rates. Bonds follow the laws of supply and demand. The more popular or less plentiful a bond, the higher the price it can command in the market.