If you first learned how to think about saving and investing as I did, from a passbook savings account, bond funds can seem like a world turned upside down. I was reminded of this a few days ago when an acquaintance told me that he planned to move a maturing CD into a bond fund.

He asked me about some alternatives. We spoke the same language. We both used the words “interest rate” and “principal.” But like Paul Newman and Strother Martin in Cool Hand Luke, what we had here was a failure to communicate.

Investing in 3D

When I opened my first savings account, I fancied myself a smart saver. I surveyed the local banking landscape and decided where to deposit my sack of rolled coins based on a single metric: the interest rate. The higher the rate, the better.

What makes sense with savings accounts, CDs, and other FDIC-insured instruments, however, can lead you astray with bond funds. The selection of a savings account is a one-dimensional decision. Bond fund selection has three: the yield (or interest rate), risk, and cost.

My recent conversation about CD alternatives remained stuck in the first dimension. “How much would this fund pay every month?” my acquaintance asked.  “Is there something that yields more?” His line of questioning soon led us deep into the risk dimension.

Credit and interest rate risk

Bond funds generally offer higher returns than bank savings instruments. As you might expect, the potential for higher returns comes at the cost of greater risk. Bank deposit accounts and CDs are guaranteed (within limits) as to principal and interest by the Federal Deposit Insurance Corporation, an agency of the federal government. Bond funds can—and do—decline in value because they’re subject to credit and interest rate risk.

Credit risk is the possibility that a bond issuer will default on interest or principal payments. Those bonds with the highest yields—high-yield or “junk” bonds—also tend to have the highest risk of default. At the start of 2008, the yield to maturity of the Barclays Corporate High Yield Bond Index, a proxy for the high-yield bond market, was 9.69%, about 6 percentage points more than the same figure for the Barclays US Treasury Index. During the darkest days of the 2008–2009 financial crisis, however, the risk of default soared, and the prices of high-yield bonds plummeted.

Growth of $1 invested in Barclays High Yield Corporate Bond Index

Source: Vanguard, Barclays Capital.

The search for yield can also lead to more interest rate risk. When interest rates rise or fall, the principal value of your savings remains unchanged. Not so with bonds. When interest rates decline, bond prices rise. When rates rise, bond prices decline. Those bonds with the most tempting yields also tend to have the longest maturities. Unfortunately, the longer a bond’s maturity (or, more technically, its duration), the greater the interest rate risk.

This graphic illustrates the mechanics.

Drivers, observe the yellow flag!

Risk isn’t good or bad. To earn potentially higher returns, you need to assume more risk. (An exception to this generalization occurs in bond funds’ third dimension, cost. When two funds with the same securities have different costs, the less expensive fund gives you more yield without more risk.)

The key is to be aware of the risks you’re taking. Over the past year, investors throughout the mutual fund industry have stampeded into longer-term bond funds and those with relatively high credit risk. They’re desperate for yields higher than the near 0% rates on savings vehicles.

The desperation is easy to understand, but caution is in order. Vanguard has published a number of commentaries and research pieces reminding investors that higher yield almost always means higher risk. After all, in Cool Hand Luke, the failure to communicate made for an unhappy ending.