Do you think your average bond investor is someone like your dull Aunt Mary, who's averse to risk and has no investments other than savings bonds?

Or do you envision a Daddy Warbucks figure who clips coupons while he puffs away on a stogie?

If you're thinking of either person, think again. Meet Investor 007. What does he invest in?

Bonds. Fixed-income bonds.

Much too cool for those tired images we mentioned, he controls investment gadgetry that's varied and sophisticated. His activities, aimed at income generation and capital preservation, help safeguard his portfolio from the risks of his equity investments. Using everything from Treasury bills to corporate issues, he understands the language of fixed income and navigates through the bond world with ease. You, too, can learn his code by checking out the basics in the Fool's Bond Center.

But beware -- danger still lurks in the world of fixed income. Investor 007 may appear nonchalant and calm, but don't be deceived into assuming that the fixed-income world is always safe. Like any form of investments, bonds can be a risky business.

Enemies of Investor 007 include the following:

  • Interest-rate risk. Changes in interest rates may affect the market value of a bond. Bond prices rise when interest rates fall, and bond prices fall when interest rates rise. So, for example, if you hold a bond with a 5% fixed coupon and interest rates rise to 7%, you might lose money if you need to see your bond before it reaches maturity, because your security would be competing in the market with newer bonds carrying higher interest rates. You might even have to sell for less than the original price you purchased it for.

  • Opportunity risk. The longer the term of your bond, the greater the risk that various negative factors may affect your investment. This danger includes the possibility that a better investment prospect might present itself.

  • Call risk and reinvestment risk. Certain bonds contain call provisions, which allow the issuer to redeem the bonds before they reach maturity. Issuers frequently do this in a period of declining interest rates, because they can sell new bonds at lower rates. While the holder receives the principal early, he or she is often unable to replace the called bond with a similar one yielding as much. The market value of a bond also may not rise above its call price.

  • Refunding risk. Certain bonds contain "sinking fund" provisions, which require the issuer to retire a specific number of bonds at various times. Often, this is done through purchases from bondholders at an established price. That raises the danger of a reinvestment risk. The issuer may also need to borrow funds or issue additional debt to service an issue subject to a sinking-fund provision, and that may affect its financial health.

  • Credit and default risk. This threat looms in the form of an issuer being unable to meet a bond's payment obligations. One way to sniff out the likelihood of a potential default is to investigate the rating assigned to an issuer's bond at agencies such as Moody's (NYSE:MCO) and Standard & Poor's, a division of McGraw-Hill (NYSE:MHP). These agencies designate ratings from AAA at the highest to D at the lowest based on their assessments of repayment ability. Bonds rated BB or below are considered junk bonds, which offer higher yields but greater risk.

  • Inflation risk. This risk presents itself if the rate of inflation rises above a bond's yield. Some bonds, such as Treasury inflation-protected securities, or TIPS, adjust for inflation.

  • Liquidity risk. Some bonds, unlike U.S. Treasuries, don't have an active secondary trading market. If you need to redeem your bond before it reaches maturity, you might receive a substantial discount to your original purchase price.

  • Event risk. This risk can masquerade in a number of guises, any of which may negatively affect a bondholder. Such occurrences can include the impact of merger-and-acquisition activity and corporate restructurings, key personnel changes, regulatory investigations, product recalls, and geopolitical events.

Once you've mastered bond lingo and are aware of certain hazards, you can begin to do some of your own sleuthing. Each week, we'll set out some clues -- for your eyes only, of course -- to help you detect the secrets of Investor 007's world. You may never say never again to fixed-income investing.

Spying on rates
The benchmark U.S. Treasuries are key rates to keep under surveillance. Corporate issues are generally priced at a spread to a Treasury rate with a similar term, based on the issuer's credit rating.

U.S. Treasury

Price

Yield)

2-Year

$100.07

4.86%

5-Year

$100.16

4.75%

10-Year

$100.21

4.79%

30-Year

$93.13

4.93%


Going forward, Investor 007 will let you in on clues to the market, as well as any intriguing developments and maybe even some hot tips. Look for his continuing adventures in the bond market in Foolish articles appearing weekly.

For related articles:

Fool contributor S.J. Caplan has been an undercover fixed-income aficionado ever since she served in banking and legal capacities covering debt underwriting as well as fixed-income derivatives. She owns U.S. Treasuries and prefers her portfolio shaken, not stirred. Moody's is a Stock Advisor recommendation. The Motley Fool'sdisclosure policyis always debonair.