Many have been pulling their money out of the low-paying money market funds and buying into bond funds in order to increase their income. With the market downturn in 2008, many investors have shied away from equities and are searching for yield. Money market funds and savings accounts are paying next to nothing.

What investors need to understand, however, is that bond funds are not without risk. Two types of risk are particularly important: credit risk and interest-rate risk. Credit risk involves the risk of the issuer defaulting on the debt. If you buy high-quality bonds (AAA or AA) you can minimize the credit risk.

Interest rate risk involves the risk of rising interest rates. The prices of bonds decline when interest rates rise,. You can measure the interest rate risk by taking note of what is called a bond’s “duration”. A bond with a duration of 3 years will lose approximately 3 percent when interest rates rise one percent (e.g. one percent loss for each year of duration). Obviously, if you hold a bond until it matures, you can eliminate interest-rate risk. With bond funds, however, you are subject to interest-rate risk because you can’t control the maturity of the bonds they purchase or whether or not the fund manager holds the bonds until maturity. You need to take care to note the duration of a bond fund before purchasing. That information is readily available on Morningstar.com.

We just attended the Financial Planning Association of Michigan’s Fall Symposium this last week. There seemed to be a general consensus of the speakers that interest rates will stay fairly low for the near term. Nevertheless, you need to take care to ensure you are not taking on too much risk with your bond investments. You can lose principle when you invest in bonds!