Bond funds sound relatively safe. Government bond funds sound even safer. So what could go wrong for an investor that owns one or more bond fund? Well if interest rates go up quickly, the answer is a lot. Bond funds trade at a net asset value (NAV) price which is based upon the market value of the securities held in the fund. The prices are set every day and will fluctuate. Typically, the higher interest rates go, the lower the prices on bonds go. This is because a bond paying 4% interest is less attractive than a bond with the same maturity date paying 5%. The 4% bond will have a discounted price to compensate and make the yields more equivalent. A 100 basis point increase in rates (+ 1%) could lead to a 10% loss in the market price of the bond. What if rates were to shoot up suddenly without warning? Could a bond fund lose 15% or 20%? This is overly simplified, but the basic tenet remains: If interest go higher, your bond fund may lose value. Trusting your portfolio manager to have properly hedged against all interest rate possibilities may be risky.
Comparing a bank CD or bank money market account to a bond fund is not an apples-to-apples comparison. Bank CDs and money markets are FDIC-insured and cannot lose value. A bond fund could be a relatively safe government bond fund, but even government bond funds pose risk. A government-issued security has lower risk of default than corporate or municipal bonds, but many government bond funds invest in quasi-government agency paper. The debacle in the mortgage-backed security market over the last year has touched on many government issues and led to losses for some bond fund investors. If the market finds an reason to question the creditworthiness of the issuer, bond prices will fall. Even if the issuer is a well known name like Freddie MAc, Ginnie Mae, or Sallie Mae.
So the risk in bond funds is two-fold:
(1) Interest Rate Risk
(2) Credit Risk
The next time someone you know compares the yield or rate on a bond fund to a bank CD or money market account, remember the distinction between the two types of investments. One poses no principal risk and the other does pose risk. That's a pretty big difference for a safety-oriented investor.
For more information on the risk associated with bond funds consult the SEC website.