Understanding bond risk is important if you plan on getting involved in investing in the bond market. Bonds can provide you with some benefits as an investor, but there are some risks associated with this type of investment. Here are some of the different types of bond risk.

Interest Risk

The first type of risk that you will need to be aware of is interest rate risk. Bonds are subject to risk associated with interest rates in the market. They actually have an inverse relationship to market interest rates. If interest rates in the market increase, the value of your bond is going to decrease. This happens because the bond is a fixed interest rate investment. For example, let's say that your bond has a face value of $1000 and pays you 4 percent interest. Then, a few years down the road, the interest rates in the market increase to 6 percent. At that point, no one is going to be willing to pay $1000 for a 4 percent bond. In that case, someone might pay you only $900 for your bond. If you are not planning on keeping your bonds until they mature, you are going to have to be aware of interest rate risk and how it affects the value of your bonds.

Inflation Risk

Another type of risk that you need to be aware of is inflation risk. Inflation is going to eat into a good portion of the profits that you can generate from your bond. Bonds typically pay a low, fixed interest rate. Because of this, it can be difficult for them to keep up with inflation in certain cases. For example, a typical figure for inflation is about 3 percent annually. If you have a bond that is paying you only 4 percent, you are essentially making only 1 percent on your investment. You have to decide if this investment is worth taking on if you get only 1 percent back. 

Opportunity Cost 

Another risk that you are going to be taking on is opportunity cost. The opportunity cost is a concept that deals with the fact that you have to give up the opportunity to invest in other things when you put your money into a bond. For example, if you put $10,000 into bonds, this is $10,000 less that you have to invest in the stock market or in mutual funds.

If you were considering putting the $10,000 into a particular stock that doubled in value over the life of the bond, you could potentially be giving up quite a large amount of return. 

Because of opportunity cost, you are going to have to weigh your investment decisions carefully. If you are the type of investor the values safety over everything else, then investing in a bond might be the best option for you. However, you are going to have to consider the potential returns you are giving up. 

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