As is the case with all investments, there is some degree of risk in investing in bonds. Two important risks are credit risk and interest rate risk.

Credit risk is the risk that the issuer will default - that is, it cannot pay the coupons or part of them, or it is unable to pay the principal on maturity. This is why bonds are rated (see question 11). Bonds issued by the government (or any stable government of economically strong countries) are considered the least risky. It is in a nation's interest that bonds issued by its government pay their coupons and the principal sum so that the credibility of the government remains strong and it can continue to raise capital through the future issuance of bonds.

A bondholder is also exposed to interest rate risk if he sells his (or buys another's) bond before maturity. Interest rates have an inverse effect on bond prices. When interest rates rise, outstanding bond prices fall and when interest rates fall, the bond prices rise. Hence, short-term bonds will mature faster and be less affected by the movements in interest rates, but they pay lower returns. Longer-term bonds will be subject to greater interest rate risk but pay higher returns.