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URL:  http://boards.fool.com/bond-and-f-i-faqs-part-1-c-25173342.aspx

Subject:  Bond and F-I FAQs: Part 1 C Date:  2/14/2007  2:15 PM
Author:  Lokicious Number:  19764 of 35838


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With all this talk about preserving principal, are there risks to Bond and Fixed-Income Investing?
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• Yes, there are many risks, some of them limited to active bond traders, others (covered here) of broader relevance.

• “Inflation Risk”:
---One of the biggest concerns with” fixed-income” investing is that the return on your investment may be so low your savings will buy less when you need to spend them than when you put the money away. This is because our costs for buying the same items usually increase due to inflation.
---The idea of a fixed income strategy is to preserve the buying power of your savings, not just the original principal.
---A return on your principal less than inflation puts you at risk of not having enough money to buy what you expected to be able to buy.
---One example of this is Passbook savings accounts, which notoriously have failed to keep pace with inflation.

• “Liquidity Risk”:
---When you need money, you need money, and if most of your money is tied up in investments that you can't liquidate quickly, you are at risk of having to sell at a bad time or of paying a penalty for cashing in before the specified date.
---Usually, to get greater liquidity, we have to accept a lower return, hence exposing ourselves to more “inflation risk.”

• “Interest Rate Risk/Trading Risk”:
---The value of tradable bonds depends on how the bond's coupon rate compares to prevailing interest rates (yields) for bonds of equivalent maturity and quality.
---If the prevailing yield is higher, the value of the bond for sale is less than its face value.
---More broadly, if the prevailing yield is higher than at the time you bought, the value of the bond will be less than you paid for it.
---This is called “interest rate risk.”
---If you hold a bond until maturity, you won't be subject to interest rate risk, because you won't be selling the bond, so its value doesn't affect you.
---With bond funds, however, you cannot escape interest rate risk, since the NAV (share price) of a fund is based on the tradable value of the bonds it holds. If the value of the bonds held by the fund is less than when you bought your shares, you will be forced to sell your shares for a lower share price than you paid.
---Interest rate risk is measured by multiplying the interest rate change in percentage points (or basis points divided by 100) by the “duration” of a bond or bond-fund. (Duration is an obscure measure, which will be discussed later.)

• “Default Risk”:
---There is always some risk the issuer of the bond will fail to continue to pay interest on its debt obligations and/or fail to pay off all or any of the face value of maturing bonds.
---This happens when companies or, sometimes, governments, are in deep financial trouble.

• “Reinvestment Risk”:
---When a bond or CD matures, or is called, you may not be able to reinvest the money for as high a yield as you have been getting.
---This is also true for income paid periodically by a bond, as opposed to instruments that compound internally.
---“Reinvestment risk” is an important consideration in choosing maturities (lo