Before you invest in a bond fund, you should know what could happen to 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 rose, look at the fund’s average duration, expressed in years. The shorter the duration, the better.
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 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 why 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.
6. Derivatives in your bond fund 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 fell 35 percent in 2008 thanks to its holdings in mortgage derivatives.
7. Foreign bonds sink as the dollar strengthens.
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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