The bond issuer may find itself in financial trouble. This risk, occurring most often with corporate bonds, can seriously diminish your return, or make it disappear completely.
Downgrading
One danger bondholders face — and one you can't anticipate — is that a rating service may downgrade its rating of a company or municipal government during the life of a bond, creating a
fallen angel.
That happens if the issuer's financial condition deteriorates, or if the rating service feels a business decision might have poor results. If downgrading occurs, investors instantly demand a higher yield for the existing bonds. That means the price of the bond falls in the secondary market. It also means that if the issuer wants to float new bonds, the bonds will have to be offered at a higher interest rate to attract buyers.
Default
The greatest risk you face is default, which occurs when the issuer doesn't live up to its promise to pay. Issuers who default on their loans can default on interest — which means you receive your principal but the interest is not paid. An issuer can also default on repayment, which means you receive some of your interest but lose your principal. Thoroughly researching bonds can help you protect yourself from some risk, but sometimes even the best-looking investments can, in time, turn out to be troublesome.
Next Steps
Learn more about bonds at www.investinginbonds.org, the bond education Web site of the Securities Industry and Financial Markets Association.
