Interest rate risk
When interest rates rise, bond prices fall. So if the fund manager has his portfolio stacked with lower interest rate paper, the prices of his holdings will fall resulting in a lower net asset value (NAV). On the other hand, if interest rates fall, the prices of his holdings rise and so does his NAV.
The longer a bond's maturity, the greater the interest rate risk. A bond fund with a longer average maturity will see its NAV react more dramatically to changes in interest rates as the prices of the underlying bonds in the portfolio increase or decline.
Credit risk
Bonds carry the risk of default, meaning that the issuer is unable to make further interest or principal payments. They are rated by individual credit rating agencies to help describe the credit worthiness of the issuer. Higher the credit rating, lower the risk and lower the returns. Lower the credit rating, higher the risk and higher the return.
Liquidity risk
If the credit rating gets downgraded or the current interest rates are much higher than the coupon rate, then the bond would face liquidity issues because finding a buyer would no longer be easy. Liquidity risk describes the danger when one has to sell a bond in the secondary market but is unable to find a buyer.
While at any given point, all these risks exist, there are different phases in the interest rate cycle and in the history of the debt market where one particular type of risk has taken center stage. During the period from 1997 right through 2003, huge money was made on interest rates because during this period rates came down from 14 per cent to 5 per cent (10-year yields). From then on till 2008, money was made by taking credit risks when BBB rated companies were borrowing at 14-15 per cent. In 2008, it was liquidity risk that gained prominence though credit risk too had its place.
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