As with all investment ventures, investing in bonds also carries some level of risk. Bond investment is indeed one of the safest forms of investment. However, this does not mean that it is completely risk-free. Any potential investor should know and understand these risks. The level of risk may vary with the type of bond and the issuer.
Interest rate risk is the negative effect that changes in the market interest rates may have on your investment. Fixed-income securities such as bonds usually have prices that fluctuate in the opposite direction to interest rates. This applies if you have to sell your bonds before they mature. If the interest rate has gone up, then you will have to sell your bonds at a lower price. Note that bonds with longer maturity periods are most vulnerable to this.
Inflation risk is also important to note. What inflation does is to reduce the value of your bond, even though the principal amount may remain the same once the bond matures. Thus, what you would have purchased before inflation requires a greater amount now. Floating-rate bonds are however guarded against this since their interest rates are adjusted regularly.
There are bonds that have a call provision. This provision allows the issuer to repurchase the bonds at a specified price before the bond matures. This usually happens when the interest rates have fallen substantially since the bonds were issued. This may lead to reinvestment risk. For an investor who did not intend to sell the bond, the immediate reaction would be to invest the recovered amount. However, the returns will now be lower than the initial bond purchase since the bond prices have now gone up.
Default risk is the risk that the bond issuer will become incapable of repaying the bond. This would mean that you would lose whatever money you have invested in bonds. Government bonds hardly carry this risk, but corporate bonds do. A company may be up one day and collapse the next, carrying with it your investments.
Downgrade risk refers to the chance that a high-rating bond that you have purchased may lose its ratings in the market. If a credit rating agency such as Standard and Poor's lower their ratings on a bond, the prices of that bond are likely to fall. This means that if you have to sell the bond, it will be at a loss. In addition, there is also liquidity risk, which means that once you decide to resell your bonds, there may be no buyers for it. This however, does not apply to government bonds, as they can always be sold.
Depending on maturity period of your bond, its rate of return, the bond issuer and speculations about the market trends in the future, you can more or less measure the amount of risk that your investment carries. Always remember that bond investment is really a game of chance, and risk is component of life itself.