Bonds have a reputation as being a conservative investment. But that doesn’t mean that bonds are always safe.

If you are following the basic principles of investing, some portion of your investment portfolio is likely invested in bonds. Bonds are debt obligations of corporations or governmental entities, and are often referred to as “fixed income”investments. When you buy a bond, you are lending money to the issuing entity(either a government or a corporation) and they are promising to pay you back the face value of the bond, plus interest, over a fixed period of time.In your retirement plan, you are investing in bond funds, or mutual funds with the investment objective of maintaining a portfolio of bonds. The manager of the bond fund buys and sells bonds in order to try to maximize the value of the portfolio.While we typically think of equity funds as being the risky investment and bonds as the “safe” investment, bond funds can be risky too because their value depends on the market price of the bonds in the manager’s portfolio. But remember, risk and return always go hand in hand. So what type of risk do bonds represent and what can you do about it?  

Risk of Non-Payment

Any time you lend money, you risk the possibility that you will not be paid back.This is the principal risk posed by bond funds. Short term U.S. bonds tend to be the safest, while longer duration bonds to corporations especially smaller companies pose much more risk of non-payment. The longer the duration of the bond, the more unanticipated factors can impact the borrower’s ability to repay.However, these riskier investments also have a much higher potential return. The more likely it is that the borrower may not pay you back, the more interest the lender (you!) can demand. So long as the borrower does actually fulfill his debt,these riskier investments will pay a much higher return than a safer investment.If you are concerned about the risk of non-payment, you can move a portion of your portfolio into shorter term, higher quality bonds. Just remember that your potential return will also decline.

Interest Rate Risk

The value of your bond fund is also very much connected to current interest rates. Remember that the bonds held in a bond mutual fund are commodities - they have a value and are bought and sold at the current market price. When a bond is issued,its yield is based on the interest rate in effect at the time of issuance. If interest rates are going up, then the bond issued at the lower interest rate is no longer as valuable as a new bond issued at the higher interest rates. To sell a bond at a lower interest rate, the price for that bond will have to be reduced. As the prices fall, the value of your bond fund declines as well, reflecting the reduced demand for existing bonds issued at lower interest rates. Interest rates are currently at historic lows. This means that bond funds are now particularly sensitive to interest rate fluctuations. Because rates are already at all-time lows, interest rates are unlikely to decline further. If interest rates fluctuate, their only direction is up.

Inflation Risk

Rising prices, which can accompany a growing economy, also pose a significant risk to the value of your bond funds. When inflation is on the rise, that means that a dollar has more purchasing power today than it will tomorrow. When you invest in bonds, you are lending money today with the hope of being paid back tomorrow. If prices are rising, when you are paid back,your money will not be worth as much. In order to encourage investors to buy bonds in such an environment, the bond prices will have to fall and interest rates will have to increase. While this may be a good time to buy bonds, the manager of the bond portfolio will find that the bonds he is currently holding are worth less and the value of your portfolio will decline.A 

Diversified Portfolio

Understanding the risks associated with bonds helps to understand how to utilize bonds in a diversified portfolio.Diversification means building a portfolio that includes different types of securities. Since bonds tend to do well when stocks don’t, including both bonds and stocks in your portfolio helps to ensure that some portion of your holdings is always doing well. If you have moved a large portion of your portfolio into bonds due to your concerns about the recent ups and downs ofthe stock market, remember that all types of investments have some risk. A diversified portfolio including a mix of stocks,bonds, and cash equivalents is the foundation of sound investing.

Go online today at https://myplanconnection.com to learn more about the investment options available in your retirement savings plan. Once logged into your account, you can access each mutual fund’s prospectus, a Morningstar synopsis of the fund, and fund performance data.