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For investors burned by their equities exposure during the 2008 downturn, seeing bonds simultaneously outperform suggested a safe haven for steady returns. A closer look at how bonds work reveals that they're also not without their risks, however.

What is a Bond?
In their simplest form, bonds are loans. When buying a bond, you become a lender to a company (such as Fletcher Building NZX: FBU or an institution such as the New Zealand Government). Your loan lasts a certain period of time � until the bond reaches its maturity date � and you get a set income payment periodically (commonly known as a coupon) as interest on the loan. As long as the company or institution does not go bankrupt, it will also pay back the principal on the bond, but no more than the principal. This is where many Kiwi investors lost out in the finance company meltdown. These companies no longer had the ability to service their creditors (the bondholders), and these investors in most cases consequently lost significant portions of their principal.

Two Basic Types of Bonds
There are two basic types of bonds: government bonds, and corporate bonds. Government bonds are issued and serviced by a sovereign government. They typically offer a modest return with low risk, although many less-developed countries can only issue bonds at higher interest rates, because of their greater risk of default. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return compared to government bonds, concerns over the health of many developed market governments' finances notwithstanding.

To determine the appropriate return, the risks must be estimated. The two primary forces that govern the performance of bonds and bond funds are the risk of interest rates moving against expectations (interest rate sensitivity), and credit risk.

Interest Rate Risk
Bond prices move in the opposite direction to interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. This is because, holding all else equal, when interest rates rise you should be able to buy the same bond you currently own but with a higher interest rate. This makes the bond you currently own less attractive, since it pays a lower interest rate to what you can buy out in the market. This makes your current bond worth less than what you bought it for, and less than the bond for sale.

For example, if you buy a 10-year bond paying a coupon (that regular income payment) of five percent per annum for $100, and interest rates go up such that any newly-issued 10-year bond has a coupon of say six percent, the price at which you can sell your existing bond is going to be less than the $100 you paid. Holding the bond to maturity until it expires avoids this price volatility, in which case you receive your $100 at the end of the term, although the market value of your bond will fluctuate until it matures.

Figure 1. New Zealand Official Cash Rate and 90-Day Rate, 1999 � 2011

Central banks lowered their interest rates dramatically during 2008 � 09 in response to the global financial crisis. The Reserve Bank of New Zealand, for instance, cut the Official Cash Rate on seven successive occasions between July 2008 and April 2009, taking the Cash Rate down from 8.00 to 2.50 percent over those nine months (Figure 1). This drove up returns for existing bondholders. However, as economies recover and interest rates rise, bonds which have been priced underestimating the potential speed and strength of the interest rate rises could experience negative returns.