With interest rates so low the last few years and investors afraid to invest in stocks, there’s been a surge in bond buying. In more normal times, many people avoid bonds because bond returns are generally lower than stocks. Some view them as stodgy and have only turned to them recently because they are hungry for earnings of any kind.

Unfortunately, many investors don’t really understand the risks involved with investing in bonds. Many think bonds are safe investments. If you know what you’re doing they can be quite safe. But if you don’t know what you’re doing, you can lose much more than you might have ever thought. Following are some things to watch out for:

First of all, all bonds carry the risk of default, or credit risk. That’s the risk involved if the issuer of the bond defaults, typically due to bankruptcy. Do you recall how the bondholders of General Motors were recently left holding the bag when GM went through bankruptcy? Bonds are rated by various ratings agencies (e.g., Moody’s and Standard & Poor's) with somewhat differing ratings schemes. Moody’s uses the following ratings: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with “Aaa” the best and “C” the worst. Standards and Poor’s ratings are similar, ranging from the best, “AAA” to the worst, “D”. Both services provide the ratings free on the Internet. Moody’s requires a log in, but it’s free to register.

One way to mitigate the credit risk, besides buying high quality bonds, is to spread the risk by buying a bond mutual fund or bond exchange traded fund (ETF). By investing in a bond fund you will own a share of a large number of different bonds, thereby providing diversification and reducing the risk, should any one bond default. You can check the average credit quality of the mutual fund or ETF by looking the fund up, online, via the Morningstar® website at Morningstar.com. A mutual fund with an “AAA” average credit quality will be much less risky than a fund with a “BB’ average credit quality.

The other significant risk with buying bonds is interest-rate risk. When interest rates go up, bond prices come down and vice versa. It makes sense if you think about it. A $1,000 bond with a 5% coupon (i.e., the bond pays 5%, or $50 in interest annually) will drop in price to $833.33 if interest rates go up to 6% ($50 divided by $833.33 = 6%). In other words, if interest rates rise to 6% for similar bonds (i.e. similar credit quality and maturity), no would buy your bond for $1,000, since it’s only paying 5%. They would only pay $833.33, since that’s the amount that would provide a yield equivalent to other similar bonds.

You can eliminate interest-rate risk, if you hold the bond to maturity. If interest rates rise or fall while you own the bond, the bond price will fall or rise, respectively. As your bond approaches its maturity date, the price will move towards the bond’s face value (typically $1,000). As a bond approaches its maturity, the default risk gets smaller and smaller, and the interest rate impact on price diminishes to zero. Therefore, if you buy a very high quality bond and hold it to maturity, you can minimize the chances of losing anything on your investment.

Another way to mitigate interest-rate risk is to buy shorter term bonds when there is reason to believe that interest rates will rise. The longer the maturity, the greater the interest rate risk of a bond. With interest rates extremely low right now, long-term bonds carry much more risk than short-term bonds. The same holds true for long-term mutual funds versus short-term mutual funds. Thus, in the current environment, short-term mutual funds are safer than long-term mutual funds.

One way to measure a bond funds’ sensitivity to interest-rate risk is to look at the fund’s “duration”. Shorter duration bond funds are less sensitive to increases in interest rates than loner duration funds. Morningstar® provides bond fund durations on its website. A discussion of the details of duration is a subject for a later blog.

In summary, bonds have risks just like other investments. Understanding those risks can help you avoid losses in your bond investments. Purchasing bonds can be relatively safe if you know what you’re doing.