Final answer:
Bonds are risky because their value is affected by market interest rates and the possibility of default. Inflation and embedded options, like callable features, contribute to their riskiness, complicating the return for investors.
Step-by-step explanation:
Bonds are considered risky investments despite making predetermined payments based on a fixed rate of interest due to several factors. Primarily, the value of a bond is influenced by market interest rates.
If interest rates rise above the bond's coupon rate, the bond's value may decrease since newer issues may offer higher returns, making the older bonds less attractive.
Conversely, if interest rates fall, the bond's value increases, but this also means that the bondholder is locked into a lower yield compared to the new market rates.
Moreover, bonds have an embedded risk of default, meaning the borrower may fail to make the due payments or return the principal amount at maturity.
This risk varies with the creditworthiness of the issuer. Inflation risk is another concern, as it can erode the purchasing power of the fixed payments over time, particularly if the inflation rate surpasses the bond's coupon rate.
Lastly, bonds with embedded options, like callable bonds, add another layer of complexity, as the issuer may choose to repay the bond before maturity, usually when interest rates have fallen, leading to reinvestment risk for the bondholder.