While government treasuries are considered virtually risk-free, not all bonds are free from risk. Understanding the various risks of investing in bonds will help you assess where to allocate your capital.
Interest Rate Risk
If interest rates rise, the price of a fixed interest rate bond will decline. This is because potential buyers can purchase a newly-issued bond at a higher interest rate.
Bonds with a long-term maturity are often locked into their interest rates. This is risky because investors are still locked into the lower interest rate from when they bought the bond if interest rates rise. Long-term bond issuers try to compensate for this risk by offering higher interest rates than short-term bonds.
The general market impacts bonds. If the stock market rises, then the value of bonds could drop as people exit bonds to enter the stock market. Additionally, a high inflation environment (like we’re in right now) will progressively diminish the purchasing power of your coupon payments.
The Creditworthiness of the Bond Issuer
The creditworthiness of a bond issuer has a significant impact on the risk of a bond. A corporation can be creditworthy when the bond is purchased and then lose credibility over time until the investment is downgraded to junk bond status.
This puts the bondholder in a difficult position, as they would likely take a heavy discount if they were to sell immediately. On the other hand, there is no guarantee that the bondholder will continue receiving interest payments or get the principal back.