This is a trick question in disguise and should be interpreted as " Provide an arguement against the view that bonds represent a risk-free investment."
Understand what a bond is. In simplest terms, it's an IOU from the company. You pay money, and they promise to return your money with interest in a defined period of time. Before the time is up, you can sell the bond, if you wish.
Let's take a real simple example. You buy a bond for $1,000. The company promises to pay 5% interest on it. It's a 1-year bond. So the company is promising to give you your $1,000 back plus $50 interest in one year.
Is it risk-free?
No. The company can go out of business. In that case, your bond might become worthless. Or the company might be able to repay some of the $1,000. But you'll have lost money.
If you hold the bond until maturity and the company pays it off, you'll get your $1,050. However, let's say inflation is 6%. You get your promised money, but you've still lost $10 of purchasing power.
Or--let's say you want to sell your bond before it's due. We used a 1-year example to make things simple, but let's say it's really a 10-year bond. Something comes up, though, and you need to sell it after 5 years. It gets complicated, but if interest rates are the same then as they are now, you'll be able to sell your bond and still make your 5%. However, if interest rates go up, your bond value will fall. (Who wants to buy a bond yielding 5% when new bonds will pay 6%? The only way to sell it is to lower its price.) So if interest rates go up and you have to sell the bond, you'll lose money.
Hope that helps.
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This is a question my lecturer has set for my finance class but I don't understand it please could someone elaborate.....
