Which of the following risks is associated with bond funds?

The correct answer highlights two significant risks associated with bond funds: credit risk and prepayment risk.

Credit risk refers to the possibility that a bond issuer may default on its interest payments or fail to return the principal amount at maturity. Bond funds, which typically invest in a diversified portfolio of bonds, are subject to credit risk because the quality of the underlying bonds can vary widely. If bonds in the fund experience downgrades in credit ratings or defaults, the fund’s overall value can decline, impacting investors negatively.

Prepayment risk is specifically relevant to certain types of bonds, such as mortgage-backed securities. This risk arises when borrowers pay off their loans earlier than expected, usually in a declining interest rate environment. When prepayments occur, the bond fund may have to reinvest the returned capital at lower interest rates, leading to a reduction in income for the fund and its investors. The unpredictability of when these prepayments will occur adds another layer of risk to bond funds, as it can affect the expected cash flows and overall yield.

Other risks may also be present in bond funds, such as foreign exchange risk in the case of funds investing in bonds denominated in currencies other than the investor's home currency. However, these are not the defining risks typically