Risks of Investing in Bond Funds

Bond funds are subject to a variety of risks. Unlike bank deposits or money
market funds, the value of a bond fund goes up and down. In 1994 investors
saw that bond funds can sometimes be as risky as stock funds, as a rapid rise 
in interest rates caused long-term bond funds to lose 8% of their value.

Before investing in any bond mutual fund, an investor should consider these
risks:

Interest rate risk. Bond funds decrease in value when interest rates
rise, and they increase in value when rates fall. The risk that a bond fund
will rise or fall in value is known as interest rate risk, and the longer a
bond fund's maturity or duration, the greater the interest rate risk.
Investors can reduce but not eliminate interest rate risk by
concentrating on short- and intermediate-term bond funds. 

Income risk. In periods of declining market interest rates, a bond fund's
interest income may fall, so an investor seeking current income could see
that income reduced when interest rates decline. Income risk is higher for
short-term bond funds and lower for long-term funds, because
short-term funds hold bonds for a shorter period of time than do
long-term funds. As interest rates change, short-term bonds mature and
those assets must be reinvested at the new higher or lower interest rates. 

Call risk. The term call risk refers to the possibility that some bonds can
be called (redeemed by the issuer before they mature) when the issuer
believes that doing so would be economically advantageous. This usually
occurs when interest rates fall below the rate specified on the bond.
When a bond is called, the bond holders must then reinvest their
money often at a lower yield. A similar risk prepayment risk affects
mortgage-backed securities such as Ginnie Maes (Government National
Mortgage Association securities). When interest rates fall, many
homeowners pay off their mortgages by refinancing, so the securities
backing those mortgages must also be paid off. 

Credit risk. Bond investors can lose money if an issuer defaults or if a
bond's credit rating is reduced. Because a mutual fund invests in many
bonds, the possibility that a single default would significantly hurt
investors is reduced. Credit risk is typically lowest with U.S. Treasury
bonds, followed by U.S. government agency bonds, then by corporate
and municipal bonds that have high ratings. Investors in high-yield bonds
and bond funds are subject to greater credit risks, especially in an
economic downturn. 

Inflation risk. A bond investment can lose purchasing power as prices
rise so inflation risk is a serious concern for anyone relying on that
income to pay for future needs. If inflation ran at 3% for five years, for
example, the value of a $100 payment check would be reduced to $86 in
terms of actual purchasing power. In the long run, inflation can have a
dramatic effect on the value of bonds, which typically include no potential
for growth.

Bonds With Inflation Protection

To address inflation risk, the U.S. treasury introduced a new type of bond in
1997 the Treasury inflation-indexed security. The interest rate paid by the bond
will remain constant during the life of the bond, but the principal will be adjusted
semiannually to reflect inflation. In periods of rising prices, the principal of a
Treasury inflation-indexed security will increase. This means that the interest
payments will also rise because they are based on a larger principal amount. As
a result, the buying power of the interest payments and the principal should
remain steady even during periods of rapid inflation. 

Of course, prices don't always rise. In a period of deflation (in other words, a
time of falling prices), the principal amount of a Treasury inflation-indexed
security might be reduced. However, when the principal amount is repaid at
maturity, the investor will receive the larger of the inflation-adjusted principal or
the face amount even if deflation had reduced the adjusted principal amount to
a sum that is less than the security's face amount.

If this new type of bond is well received by investors, the U.S. Treasury plans to
offer them in a variety of maturities. Today, there are a few mutual funds that
specialize in these inflation-indexed bonds.

Manager risk. Many funds are actively managed, meaning that the
investment adviser uses economic, financial, and market analyses when
deciding which bonds to buy or sell. Manager risk refers to the possibility
that the investment adviser may fail to choose an effective investment
strategy or to execute that strategy well. As a result, an investor in the
fund may lose money. 

Other risks. Some bond funds also may be exposed to event risk, the
possibility that some corporate bonds may suffer a substantial decline in
credit quality and market value because of a corporate restructuring for
example, a merger, leveraged buyout, or takeover. Restructurings are
sometimes financed by a significant increase in the company's debt an
added burden that could hurt the credit quality of the company's existing
bonds. Still more risks can arise from the use of derivatives, such as
futures or options, whose values are linked to (or derived from) the value
of another asset or commodity. Because different derivative-trading
strategies carry different amounts of potential risk and reward, some
funds limit the use of derivatives by their portfolio managers.