Low Yields

When it comes to bonds and bond funds, the rate of return and the level of risk go hand in hand. The higher the yield on your bond fund, the greater the risk, and vice versa. If you need to keep your money perfectly safe, you can invest in U.S. Treasury bonds, but the interest rate you receive will be quite low. In many cases you could get a better rate of return, and absolute safety, by investing in a certificate of deposit from your local bank. You can seek out a higher rate by looking to so-called high-yield bond funds, but the bonds these funds contain can be just as volatile and risky as stocks. High-yield bonds are also known as junk bonds, so named because the companies involved have poor credit ratings and, therefore, a higher risk of default.

Interest Rate Risk

Bond funds are subject to interest rate risk, and that risk can be quite significant, especially in a low interest rate environment. When interest rates are at historic lows, they have nowhere to go but up. When rates do spike up, the net asset value of the bond fund can decline significantly. You can mitigate this risk somewhat by choosing bond funds with an average duration of just a few years, but you still have some risk even with a short duration fund. You have this interest rate risk in individual bonds as well, but it only applies if you need to sell the bond early. While the value of your bond goes down when interest rates rise, you are not affected if you hold the bond to maturity and continue to collect the interest payments.

High Costs

References

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