Just because bonds have a reputation as conservative investments doesn't mean they're always safe. Any time you lend money, after all, you run the risk it won't be paid back. Companies, cities and counties occasionally do go bankrupt or default on their debts for extended periods. During the first quarter of 2009, in the midst of the worst economic crisis since the Great Depression, the default rate on speculative corporate debt rose to more than 7%, compared to the historic average rate of 4%. Only U.S. Treasury bonds alone are considered rock-solid.

Paradoxically, another source of risk for certain bonds is that your loan may be paid back , or "called." This is known as prepayment risk. While it's certainly better than not being paid back at all, it forces you to find another, possibly less lucrative, place to put your money. When you buy a bond, the prospectus will indicate whether a bond is callable and give you a "yield-to-call" figure. If you have a choice, you probably want to buy a bond without the call option. The only time you might a callable bond is when you're convinced that interest rates are going to rise before your bond matures. In that case, if your bond is called, you'll have the option of moving into bonds with greater interest payments.

Inflation

By far, the greatest danger for a buy-and-hold bond investor is a rising inflation rate. Nothing spooks bond traders more than cheerful headlines about full employment or strong economic growth. When the economic news is good, the bond markets often take it as a bad sign -- a harbinger of an impending period of rising consumer prices. The hotter the economy, the worse the threat. And the more downward pressure on bond prices.

Why is inflation such a problem for bondholders? Think about it this way: Rising prices make today's dollars worth less in the future than they're worth today. Since a bond can lock up your money for as long as 30 years, a rising rate of inflation can have a particularly corrosive effect.

Take a look at the applet above. What it shows is a 10-year bond with a 4% coupon and a $1,000 face value. If you click the "stack payments" button, you'll see that if you assume no inflation, the value of those future payments is $1,400. But if you dial up the inflation rate, that future value erodes quickly. Even if you estimate conservatively -- assigning a 3% inflation rate, for instance -- your future value sinks to $1,100, a 21% haircut.

All this explains why bond traders live in a hall of mirrors. What you or I might consider good news, they often consider bad. The bond market itself is a minute-by-minute referendum on the threat of inflation. If the threat is high, prices fall and yields -- or interest rates -- rise. This is often an excellent time to bonds. But if you own them already, you're stuck.

Yield vs. Risk

Inflation risk, interest-rate risk, credit risk and prepayment risk are all figured into the pricing of bonds. The more risk, the higher the yield. It's also true that investors demand higher yields for longer maturities. The reason for that is obvious -- given enough time, a once-healthy corporation can go bankrupt and suddenly lose the ability to pay its obligations. Inflation could run rampant, seriously eroding the purchasing power of that $1,000 you're supposed to get back in 10 years. These things are unlikely or you'd never invest in the first place. But the longer you tie your money up in a bond, the more at-risk it is statistically.

The credit quality of companies and governments is closely monitored by the two major debt-rating agencies; Standard & Poor's and Moody's Investors Service. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings -- expressed as letters (for example: Aaa, Aa, A, etc.) -- help investors determine the interest rate that a company or government has to pay when it issues bonds. The market determines the price -- and thus the yield -- after that.