5 Caveats When You Buy Bonds

From Kiplinger's Personal Finance magazine, March 2009

1. Bond prices move inversely with interest rates. So when rates rise, your bonds drop in value. This isn't a problem if you buy individual bonds and hold them until maturity. But it's a major risk for investors in bond funds, which price their shares according to the market each day.

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2. The silent wealth killer of inflation eats into the purchasing power of your investments and is often accompanied by rising interest rates. For now, the recession is keeping inflation in check -- and even leading to fears of deflation, a period of falling prices. But government efforts to stabilize the economy could lead to a period of above-average inflation once the recession ends.

3. The chance that an issuer won't pay you back at all is called credit risk. Treasury bonds have essentially no credit risk. Although municipalities occasionally default, credit risk for the tax-free bonds they issue tends to be low. For munis and corporate IOUs, an issuer's credit rating is your best tool for gauging credit risk (AAA or Aaa are the highest rankings), although those ratings are not infallible.

4. Although falling interest rates drive prices higher, they aren't a blessing if an issuer can call its bonds, or redeem them early in order to issue new bonds at lower rates. In that situation, you're stuck with buying new bonds that pay less or finding something better to do with your money.

5. Occasionally a major event, such as a natural disaster or a leveraged buyout that leads to the issuance of more debt, will hurt a borrower's creditworthiness -- in turn lowering the value of its bonds. For example, the ratings of bonds issued by many airlines were downgraded in the wake of the September 11 terrorist attacks.

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