And watch out if interest rates rise and bond ratings decline at the same time. If your AAA bond falls to AA at the same time that interest rates rise 1 percent, you'd lose 15 percent of your money. If interest rates rise to 3 percent and the bond falls to DDD, you lose 44 percent of your money. And in a truly terrible, but possible scenario, if interest rates rise to 3 percent while a bond falls to junk value (BB), you would face a whopping 83 percent loss.
Fortunately, there are several ways you can reduce these risks. First, pay attention to a bond's duration. That term refers to the life of the bond. (It's not the same as maturity, which is the date the issuer is to return your principal; duration refers to the average life of a bond, which is usually shorter than its maturity. Ginnie Maes, for example, have a 30-year maturity date, but typically have a duration of only seven years because people refinance, default or sell their homes -- thus paying off their mortgages -- long before the loan is due to mature.)
Long-term bonds are more sensitive to interest rates than short-term bonds.
Therefore, you can cut your interest-rate risk by limiting your bonds to those that have durations of seven years or less -- and the shorter the duration, the less risk.
Second, limit your bonds to those that are unlikely to experience cuts in their credit rating. Ideally, this means buying bonds issued by and fully backed by the U.S. government. Municipal bonds and corporate bonds can be downgraded and are therefore riskier. (Interestingly, some will argue that the safest bonds are those that have already been downgraded: Junk bonds are worth buying because their ratings have nowhere to go but up.)
Third, and more importantly, don't overweight your portfolio with bonds. Maintain a meaningful allocation to stocks, real estate, natural resources, precious metals, and oil and gas -- assets that are not (or not directly) affected by interest rates and credit ratings. Diversification helps when facing the challenges of a financial marketplace in turmoil.
Imagine the poor soul who invested his money in stocks in 2008 -- and watched the S&P 500 fall 38 percent. Determined not to let that happen again, and desperate to avoid further losses in the stock market, he moves his money to bonds -- and unwittingly sets himself up to lose another 40 percent when interest rates rise.
Don't let that happen to you. If the stock market's recent performance has tempted you to sell stocks low, you might buy bonds high without knowing it -- and it's always what you don't know that hurts you.
That's why you should let your portfolio be managed by investment professionals who know what they're doing.