Final answer:
Bonds carry an interest rate risk, which is the chance that their value will decline when interest rates fall, reflecting a decrease in demand for money. Government bonds are low-risk in terms of default, but their value can fluctuate due to market conditions. Diversification can help reduce investment risks.
Step-by-step explanation:
The question explores the reasons why bonds are considered to have inherent risks, even though they are designed to provide fixed payments at regular intervals. These fixed payments from bonds are termed as the interest rate risk, which refers to the possibility that the value of bonds will decrease due to a change in the general level of interest rates. When the demand for money falls, interest rates are likely to decrease, and the market price of existing bonds with higher rates becomes less attractive, hence their value declines. This impact on the bond's market value represents an interest rate risk.
Government bonds are generally considered low-risk assets since governments are expected to honor their debt obligations. However, bonds are subjected to several types of risk, including market risk and purchasing power risk, which can affect their value. The key to mitigating risks involves diversification, such as investing in different types of bonds or other financial instruments.1