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| Risks of Fixed Income Investing |
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| Despite the generally conservative nature of many fixed income investments, such as investment grade-quality bond funds and money market funds, and the tendency of fixed income investments to be more predictable than stocks, investors should be aware that bond funds and individual bonds do carry some degree of risk. |
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| Bond funds achieve diversification by holding many securities, so are generally less risky than individual bonds in that regard. However, there are some risks that may apply to both investments, as noted below. |
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| Interest Rate Risk |
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| If interest rates rise, bond prices usually decline. If interest rates decline, bond prices usually increase. This risk exists because new bonds are likely to be issued with higher yields as interest rates increase, making the old or outstanding bonds less attractive. The longer a bond fund's maturity, the greater the impact a change in interest rates can have on its price. If you don't hold your bond until maturity you may experience a gain or loss when you sell your bond. |
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| Credit Risk |
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| Bonds carry the risk of default, which means that the issuer is unable to make further income and principal payments. Many individual bonds are rated by a third party source such as Moody's or Standard & Poor's to help describe the creditworthiness of the issuer. U.S. Treasury bonds have backing from the U.S. Government and thus no default risk. Although they are not directly backed by the full faith and credit of the U.S. Government, government agency bonds, such as those issued by Fannie Mae and Freddie Mac, are considered to be high credit quality. |
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| Since a bond fund is made up of many individual bonds, diversification can help mitigate the credit risk of a downgrade, which would affect bond prices, or a default. Bonds are typically classified as investment grade-quality (medium - highest credit quality) or below investment grade-quality (commonly referred to as high-yield bonds), as are bond funds. Credit risk is a greater concern for high-yield bonds and bond funds that invest in lower-quality bonds and bonds of issuers whose ability to pay interest and principal may be considered speculative. Some bond funds may invest in both investment grade-quality and high-yield bonds. It's important to read a fund's prospectus before investing to make sure you understand the fund's credit quality guidelines. |
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| Inflation Risk |
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| Because a high inflation rate can erode the real value of the income you receive, inflation can jeopardize any fixed income stream on which you may be counting. To combat this risk, you may want to consider a bond or bond fund that has its principal adjusted for increases in the inflation rate, such as U.S. Treasury Inflation-Protected bonds (TIPs) and bond funds that invest in TIPs. |
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| Call Risk |
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| A callable bond has a provision that allows the issuer to call, or repay, the bond early. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds, he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments. |
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| Prepayment Risk |
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| Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk. Similar to call risk, prepayment risk is the risk that the issuer of a security will repay principal prior to the bond's maturity date, thereby changing the expected payment schedule of the bonds. This is especially prevalent in the mortgage-backed bond market, where a drop in mortgage rates can initiate a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage-backed bonds receives his or her principal back sooner than expected, and must reinvest at lower, prevailing rates. |
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| Reinvestment Risk |
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| During periods of declining interest rates, you may be forced to buy new bonds at lower, prevailing interest rates as your existing investments reach maturity. Since bond funds are professionally managed, the fund's manager does this for you, searching for the most attractive bonds in any interest rate environment. |
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| In addition to the risks associated with fixed income investments described above, you should keep some other factors in mind before making an investment decision. |
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| Most importantly, investors should be aware that with either a bond fund or an individual bond, prices may fluctuate, as the securities are affected by economic and other factors. As a result, the value of your investment may increase or decrease. |
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| Bonds held to maturity will return the full principal amount to the bondholder upon maturity. However, those sold prior to maturity are subject to gain or loss depending on the market price at the time of sale. |
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| The price of a bond fund may vary daily as the underlying bond prices change. Upon selling shares in the fund, the shareholder will realize a gain or loss depending on the NAV of the fund at the time of sale. |
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| As bond funds buy and sell bonds of different coupon rates, the income derived from these bonds, and passed on to shareholders, may vary. |
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| As with any type of investment, there is a trade-off between the risk you are willing to assume and the potential return you could receive. The higher the potential reward or return, the greater the risk inherent in a bond fund or individual bond. For example: |
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Government bond funds and U.S. Treasury securities offer the lowest level of risk but they also typically offer lower yields |
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Bond funds and bonds with shorter maturities or duration will likely have less price volatility, but may have lower yields |
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Because bond funds are diversified across securities and professionally managed, they may be a better choice for many investors |
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