People are seeking refuge from the volatility of the stock market by switching to bond funds. What they don’t realize is that you can lose just as much money in a bond fund and just as quickly. Bonds have their own set of risks — even the bonds in the well-managed fund that have been chosen for your 401(k) plan. That’s not to say you shouldn’t diversify your retirement investments into bonds. But you should understand the risks in buying bonds.

Credit risk

Not all bonds are equally “safe.” U.S. Treasury bonds have the highest “triple A” rating — even though our country is deeply in debt! All bonds carry ratings, ranging from AAA down to BBB-minus. Below that level, bonds are considered “non-investment grade.” That means there is serious doubt about whether the company will earn enough to pay the interest, or worse, enough to repay the principle when the bonds mature. A company’s financial situation may change quickly — before even the ratings agencies catch up! General Motors’ bonds (and Chrysler’s just before the bankruptcy filing) fall into this category. They started out as very good credits, but as the auto business fell apart, there is little chance there will be enough in assets — even in bankruptcy — to pay off their bonds in full. In a bankruptcy proceeding, bondholders stand first in line, but there may not be enough assets to repay them completely.

The lower the likelihood of repayment, the higher the interest rate that will be offered by a company (or municipality) that desperately needs to borrow money. That’s why you should look twice at tempting, high-yield bond funds. Moody’s, a bond-rating agency, estimates that in 2009, a record 14 percent of high-yield bond issuers may default. If you’re going to buy bonds, you should be aware of the credit ratings of the bonds, or bonds in the bond fund, and understand that the higher yield is a function of higher risk!

Interest rate risk
Interest rate risk is another kind of risk inherent when you buy bonds, even the top-rated bonds. That’s the risk that you’ll lock up your money for 10 or 20 years today — even in a top-rated U.S. Treasury bond — and then the general level of interest rates will move higher. You’ll be stuck with your low-yielding, fixed-rate bond for years. Big mistake. When interest rates move higher, bond prices drop to compensate. For example, in March, you could have purchased a $1,000, 10-year U.S. Treasury bond with a fixed rate of 3.12 percent. But now the market rates on 10-year Treasury bonds have moved to nearly 3.75 percent, as the Treasury is announcing huge, new bond sales to finance the deficit. So the current market value of your 3.12 percent, $1,000 bond has dropped to $940 if you try to sell it.

Here’s the rule: When interest rates rise, bond prices fall. You could hold the bonds to maturity in 10 years, but in the meantime, you’d be earning less interest. And the $1,000 you get back at maturity would have less buying power. In the interim, prices have fallen and so has the share price of your bond fund. The longer the “maturity” — the future repayment date — of the bond, the greater the drop in market value as interest rates rise. That’s why you should stick to short-term bonds, two years or less, if you fear a return of inflation. That way, you’ll get a chance to reinvest sooner, at higher rates.

If you own a single bond, or several bonds, or a bond fund, the principle is the same: When interest rates rise, the value of your bonds falls. When you get your monthly retirement plan statement, your bond fund could show a loss — just as your stock fund did when the stock market took a hit. The only real place to “hide” from volatility in a retirement account is a money market fund or a “stable value” fund. Otherwise, you might just be jumping out of the equity frying pan into the bond fire!