How do interest rates affect bond prices?
Generally, bond fund prices and interest rates have an inverse relationship. When interest rates move up, the price of bonds go down. When interest rates go down, the price of bonds goes up.

A hypothetical example using an individual bond helps explains why. Let's say a 20-year, $1,000 bond that pays a 6% interest rate is issued. Five years pass and the original buyer decides to sell the bond. However, interest rates have risen and new bonds are now paying 8%. Obviously, no one would want to pay $1,000 for a 6% bond when they could buy an 8% bond for the same price. But if the seller were to charge only $750, the buyer would get an effective yield of 8% (6% of $1,000 = 8% of $750). If interest rates had fallen instead of risen, the seller could ask more than $1,000 because a buyer would be willing to pay more for a bond with a higher interest rate.

Government Bonds: These bonds are issued by the U.S. Treasury and its agencies, and constitute the largest sector of the world's bond market. U.S. Treasury bonds are considered the highest quality of all bonds because they are backed by the full faith and credit of the U.S. government. (However, shares of funds that invest in U.S. Treasury bonds are not.) In exchange for this very high margin of credit safety, they have the lowest yields.
Bottom Line: Higher safety, lower yields.

Mortgage-Backed Bonds: These bonds are backed by a pool of home mortgage loans. The vast majority are issued or guaranteed by government agencies. Mortgage securities issued by the Government National Mortgage Association (Ginnie Mae) are backed by the full faith and credit of the U.S. government. (However, shares of funds that invest in Ginnie Maes are not.) Ginnie Maes offer the same high-credit safety as U.S. Treasuries.
Bottom Line: Higher safety, lower yields.

Corporate Bonds: These bonds are issued by corporations to finance expansion and other activities. They are rated based on their potential to pay interest on time and the principal back at maturity. Quality ratings are given by companies such as Moody's Investors Service and Standard & Poor's. Higher-rated corporate bonds are considered investment grade. Lower-rated corporate bonds, often referred to as below investment grade, offer higher potential returns but are considered speculative because the issuing corporation's future is deemed less certain and their risk is higher.
Bottom Line: Depending on the credit rating, may offer less safety, higher yields.
Westcore's Flexible Income and Plus Bond Funds invest primarily in corporate bonds.

However, investments in bonds and bond funds do carry risk. Three types of risk are:

Interest-Rate Risk: If interest rates rise and bond (and bond fund) prices fall, this will lower the value of your investment. All types of bond funds are subject to interest-rate risk, but you can moderate it to some degree by choosing a bond fund with a shorter duration or average maturity. Generally, the longer a fund's duration or average maturity, the higher its interest-rate risk, or the more sensitive its share price will be to changes in interest rates. 

Credit Risk: Bonds carry the risk of default, meaning that the issuer is unable to make further payments on it. Bond funds offer professional management and a range of quality ratings to help lower this risk. Credit risk is a greater concern if the fund invests in lower-quality bonds. These "junk bond" funds tend to be more sensitive to the health of the economy and health of the particular issuers rather than to interest rates. 

Prepayment Risk: A bond issuer may decide to pay off the principal of an existing bond before it matures. This risk is a particular concern with mortgage-backed bonds such as Ginnie Maes. During periods when interest rates are low and many mortgage-backed bonds are being prepaid -- because homeowners are refinancing -- it is possible for both the yield and the share price of a mortgage-backed bond fund to decline within a short period of time. This is because the fund must reinvest its assets at the prevailing rate, which is generally lower during times when widespread prepayments are occurring. This potential risk is what allows Ginnie Maes to provide higher yields than U.S. Treasuries. 

How can I balance risk versus reward?
As with any type of investment, there is a trade-off between the risk you are willing to assume and the potential return you will get. The greater the risk of a bond fund, the higher the potential reward, or return. With a bond fund, one of the risks is that prices may fluctuate and the value of your investment may increase or decrease. There is a range of risks associated with bond funds with short-term bonds fund carrying the least risk and global funds carrying the highest risk. Create a portfolio that allows you to manage risk by matching it to your risk tolerance and time horizon.

Diversification: Investing a portfolio in securities with different risk levels is one way to achieve diversification. In general, bonds are considered to carry less risk than stocks and therefore are used to help investors reduce their exposure to market volatility. Using bond funds to diversify a portfolio can help investors reduce their risk of loss while still maintaining the potential for a competitive return.

The table below illustrates how diversifying with bond investments can help cushion a portfolio against market risk.

This hypothetical chart is based on performance of common stocks (as measured by the S&P 500) and long-term government bonds (as measured by a bond portfolio constructed by Ibbotson) for the period Dec. 1926 - Dec. 2000. Source: Ibbotson Associates, Chicago, Analyst Software. All rights reserved. The indexes are unmanaged and include dividend reinvestments for the S&P 500. Unlike common stocks, U.S. government bonds offer a fixed rate of return and guarantee payment of principal (if held to maturity). Unlike U.S. government bonds, mutual funds are not insured or guaranteed by the U.S. Government. Not intended to imply past or future performance of any Westcore fund.

** Certificate of Deposit is a debt instrument issued by a bank that offers a fixed rate of return. Maturities usually range from a few weeks to several years. Interest rates are set by competitive forces in the market place. a 1-year CD is a time deposit requiring the funds to be invested for a 1-year period to earn a stated return. CDs are insured by the FDIC.

An investment in a money market mutual fund is not a deposit of a bank and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market mutual fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market mutual fund.