One of the first lessons taught about investment is the concept of portfolio diversification. A significant component of financial security is found in \"spreading the risk\" between various classes of investment. Asset allocation is another term for this diversification. A classic distinction to be made in such classes is between equities (stocks) and debt (bonds). An investment in the stock of a company is generally made to seek a higher return by accepting greater risk. A bond, on the other hand, trades return to minimize risk.
Bonds are sold by the government or a corporation as debt instruments. When issued, the bond will specify the date the principal is to be repaid and an interest rate or coupon to be paid annually. Payments may be made more than once a year but the total payment for the year establishes the coupon.
The first risk in purchasing a bond is, of course, that the issuer will default on the interest payments. That raises the risk of a default on the principal itself. US Treasury bonds are the benchmark bonds issued because of their \"risk free\" nature. All other bonds, up to junk bonds, have higher interest rates or coupons because they represent higher risks.
When seeking financial security, it is essential to understand the risks to your investment portfolio. The risk that many people fail to consider in their bond purchases is the duration of the bonds purchased. Bonds are very sensitive to interest rate changes. If interest rates go up, the price of bonds with lower coupons declines. If the rates go down, bonds may demand a premium over their par value. These fluctuations are a function of the principle of return on investment. If a bond has a fixed rate of return, what someone is willing to pay is directly rated to the return that coupon will provide.
Duration is a risk factor because the further in the future the bond is set to redeem, the more likely the bond's value will be affected by interest rates. If rates go up, the bondholder is left with a lower annual return than if the money was invested at then current rates. Even though the bond may be redeemable at par value in the future, it would be sold at a discount before that redemption period. If rates go down, there is a likelihood the bond will be called and redeemed. That means interest risk is often one sided.
The safety that many people see in bonds as an investment can be undermined by the risk of bond duration.