Bonds and bond funds are subject to risks just like any investment. These include the obvious risk of the bond issuer (the borrower) defaulting on the bond but it also includes the less obvious risks of changes to interest rates and inflation.

Video Analysis: Understanding Bond Risks

To understand why changes in interest rates or inflation may affect a bond’s value you need to understand that these two economic forces are related and often correlated.

Although it is more complicated than this, assume for the sake of the next example that inflation and interest rates tend to rise and fall together.

Imagine that you own a bond that is paying 5% right now. Assume also that this rate is competitive with new bonds being issued and that your bond has a term of 10 years. Once you have held this bond for a few months, interest rates start to rise.

This may be because economic growth or inflation (also often correlated) is also on the rise at the same time. Your bond may actually lose value in this scenario.

The reason a bond will lose value when rates rise is because it now has to compete with new bond issues that are paying the new higher rate.

Assume that new bonds are now paying 8% because rates have gone up. If you wanted to sell your bond that still only pays 5% you will have to discount the price of that bond to make up the difference. The total yield on a bond is a mix of its discount from the face value and the interest rate it pays.

What this means is that if traders anticipate higher rates/inflation in the near future they will start discounting bonds now. That will create losses for bond holders or bond funds that are holding older bonds. If you held the bond to maturity you would still be paid back the principle and the 5% interest but you could have made more on a higher yielding bond, which creates an opportunity loss.

For traders interested in bonds or bond funds and ETFs who are worried about potential inflation or higher interest rates in the near term, there is a way to minimize the risk of losses. Long term bonds are very sensitive to interest rate or inflation changes and therefore can be a little riskier. By contrast, short term bonds are much less sensitive to these changes because they mature so much faster.

Traders willing to take more risk can make more from long term bond funds but they can expect more volatility. If you feel that you can reasonably forecast higher interest rates/inflation in the near term, moving into short term bonds/funds may be a great alternative once inflation or higher rates appear likely in the near term. For investors with a diversified portfolio plan, spreading their market exposure between the two bond asset-classes may be a good idea in the same way including both small cap and large cap stocks is a good idea.