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As is the case with all investments, there is
some degree of risk in investing in bonds. Two important risks are credit
risk and interest rate risk. Credit risk is the risk that the issuer will
default - that is, it cannot pay the coupons or part of them, or it is
unable to pay the principal on maturity. Bonds issued by the government (or
any stable government of economically strong countries) are considered the
least risky. It is in a nation's interest that bonds issued by its
government pay their coupons and the principal sum so that the credibility
of the government remains strong and it can continue to raise capital
through the future issuance of bonds.
A bondholder is also exposed to interest rate risk if he sells his (or buys
another's) bond before maturity. Interest rates have an inverse effect on
bond prices. When interest rates rise, outstanding bond prices fall and when
interest rates fall, the bond prices rise. Hence, short-term bonds will
mature faster and be less affected by the movements in interest rates, but
they pay lower returns. Longer-term bonds will be subject to greater
interest rate risk but pay higher returns.
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