After a bond is issued, it may be traded. If a bond is traded before it matures, it may be worth more or less than the price paid for it. The price at which a bond trades can be affected by several types of risk.

Interest Rate Risk

When interest rates fall, a bond’s value usually rises. When interest rates rise, a bond’s value usually falls. The longer a bond’s maturity, the more its price tends to fluctuate as market interest rates change. However, while longer-term bonds tend to fluctuate in value more than shorter-term bonds, they also tend to have higher yields to compensate for this risk.

Unlike a bond, a bond mutual fund does not have a fixed maturity. It does, however, have an average portfolio maturity—the average of all the maturity dates of the bonds in the fund’s portfolio. In general, the longer a fund’s average portfolio maturity, the more sensitive the fund’s share price will be to changes in interest rates and the more the fund’s shares will fluctuate in value.

Credit Risk

Credit risk refers to the “creditworthiness” of the bond issuer and its expected ability to pay interest and to repay its debt. If a bond issuer is unable to repay principal or interest on time, the bond is said to be in default. A decline in an issuer’s credit rating, or creditworthiness, can cause a bond’s price to decline. Bond funds holding the bond could then experience a decline in their net asset value.

Prepayment Risk

Prepayment risk is the possibility that a bond owner will receive his or her principal investment back from the issuer prior to the bond’s maturity date. This can happen when interest rates fall, giving the issuer an opportunity to borrow money at a lower interest rate than the one currently being paid. (For example, a homeowner who refinances a home mortgage to take advantage of decreasing interest rates has prepaid the mortgage.) As a consequence, the bond’s owner will not receive any more interest payments from the investment. This also forces any reinvestment to be made in a market where prevailing interest rates are lower than when the initial investment was made. If a bond fund held a bond that has been prepaid, the fund may have to reinvest the money in a bond that will have a lower yield.