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7 Risks That Can Sink Your Bonds

Before investing in a bond fund, know what could dampen your results.

1. Interest rates rise. In general, bond prices fall when rates go up. And the longer it takes until a bond matures, the bigger the move. For a sense of how much a bond fund would lose if interest rates rise by one percentage point, look at the fund's average duration, expressed in years.

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2. Inflation erodes the bond's value. The higher the inflation rate, the less a bond will be worth when it matures and the less valuable its (generally fixed) interest payments. Over the long term, inflation and interest rates tend to move together.

3. The bond issuer gets into trouble. A bond's credit risk is the risk that its issuer -- typically a corporation or local government -- won't be able to fulfill its obligation to make timely payments of interest and principal. A bond's price is likely to fall if investors worry about the health of its issuer.

4. Bond buyers may go on strike. During the financial crisis, investors became so fearful that they stopped buying many kinds of bonds, and their prices crashed. That's one reason floating-rate bond funds, among others, tanked in 2008.

5. Investors turn gloomy about certain kinds of bonds. The market can knock down prices for an entire sector -- be it narrow, such as tobacco-industry bonds, or broad, such as municipal bonds in general -- if investors have reason for pessimism. Lately, investors have battered tax-free bonds over concerns about the health of state and local governments.

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6. Derivatives in your bond fund may blow up. Once called "weapons of mass destruction" by Warren Buffett, derivatives, whose performance depends on the results of other investments, can wreak havoc on a fund. Just ask investors in Schwab YieldPlus, a supposedly conservative bond fund that lost 35% in 2008 thanks to its holdings in mortgage derivatives.

7. Foreign bonds add an extra level of risk. A fund that owns foreign bonds could lose value if the dollar strengthens. That's because money invested in bonds that are denominated in yen, euros, Swiss francs or other currencies gets translated into fewer bucks if the greenback appreciates against them.

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