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When you buy a bond, you face several risks:
- The risk that the bond issuer will have financial problems
- The risk that inflation will eat away at the bond’s value
- The risk that interest rates will go up
If you don’t hold a bond until its maturity date, you must sell it in the secondary market. Your bond may be worth less than its face value if interest rates are higher than when you first invested in the bond. Your bond will also go down in value if the issuer’s financial condition has deteriorated.
If you plan to hold a bond to maturity, it really doesn’t matter if the bond’s value fluctuates from day to day, as long as the bond’s issuer is able to make your interest payments and redeem the bond when it comes due.
Bond Ratings
Just as your bank won’t lend you a dime until it sees your credit rating, you shouldn’t buy a bond until you see the credit rating of the entity that issued it. You shouldn’t risk your small fortune on bonds from issuers that have financial problems.
There are several major rating services that evaluate the credit worthiness of bonds, the most common of which include:
The Standard & Poor’s top rating is AAA. A bond with a BBB or higher rating is classified as investment-grade. If you were looking at Moody’s ratings, investment grade is Baa and higher.
So-called junk bonds are rated lower than investment grade. They are also referred to as high-yield bonds, since the issuer must may more interest to entice investors to buy riskier bonds. Keep in mind the higher the yield relative to other investments with the same maturity, the more risk you are taking that the issuer will not make all of your interest payments and, even worse, will fail to repay the debt.
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