Bonds: 3 Risks an Investor Should be Aware of

When you expect returns from an investment, it will automatically include a particular risk. Now, the level of risk depends on how much return you expect. It works on a simple concept — higher the return, higher the risk.

Investments carry different types of risks, and the amount of risks involved varies as well. For example, while the equity market is riskier, debt mutual funds and bonds are less risky.bonds, which are a safer category of bonds, also carry their own share of risk.

In this blog, we will explain the risk factor in bonds and the investment strategy you should follow to mitigate them.

3 Risks an Investor Should be Aware of

No investment medium can guarantee returns to you without a hint of risk. In fact, even government backed investment avenues like fixed deposits come with a certain degree of risk.

Let us understand them in detail.

1. Credit Risk

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Simply understood, credit risk is a risk of non-payment of the money that the investor has lent to the NBFC (in the form of investing in their bonds) or default in repayment of the collateral loans by the underlying borrowers.

But where does credit risk lie when investing in bonds?

Here, the risk lies when the NBFCs fail to pay the money to investors or go bankrupt.

But wait, this doesn’t necessarily mean you will lose your money. Even if an NBFC defaults in repayment, investors will get their money back, since there is an SPV (special purpose vehicle) which has been set up, that is handled by a trustee who acts on behalf of the investor. The trustee pays off the investor from the collateral.

Now suppose the NBFC defaults in repayment, then the investor’s money may be at risk. However, there’s a provision for this too. If the loans are backed by vehicles or gold, the investment avenue can sell the gold or the vehicle and pay back its investors.

The investor’s money will be at risk only if these collaterals are not being sold in the market or if there are significant defaults in the collateral loans.

How Can the Risk be Mitigated?

Wint Wealth selects NBFCs after thorough vetting and due diligence. It also does diligence on systems, processes and other functions of the NBFCs.

Furthermore, the collateral taken from these NBFCs is generally 1.2 times the money invested. This means that even if there are 20% defaults in the collateral pool, the investors can still get their money back.

2. Liquidity Risk

Bonds have a maturity tenure of 6 to 24 months.

Which means, investors are required to hold the money till maturity. Hence, the liquidity risk involved in bonds is that investors may not be able to withdraw their money in the middle of their investment term.

Additionally, the money may get stuck for a longer period of time if the NBFC defaults in paying on time.

How Can the Risk be Mitigated?

To reduce the liquidity risk, when an investor urgently demands their money an avenue such as Wint Wealth will try to find a buyer who can invest the same amount from their waitlist.

However, no such guarantees are given and if a buyer is not found, the investor will have to wait until their investment matures,

3. Fraud Risk

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Fraud Risk in bonds is understood as a risk that involves fraudulent transactions by NBFCs.

If NBFCs offer falsified or fraudulent loans that never existed, then the investors’ money is at stake. Fraud risk may force the investor to lose the principal and the interest amount.

How Can the Risk be Mitigated?

In case of fraud, the trustee will file a legal claim against the NBFC who falsified the loans that were supposed to be kept as collateral.

However, the legal case may take years to get resolved, and it may take an investor years to retrieve their money. This can be seen in the case of secured bonds. In fact, we saw this happening in the DHFL crisis.

In bonds, the underlying pool is bankruptcy remote while in secured bonds the pool becomes part of bankruptcy proceedings on the NBFC.

However, this does not completely rule out fraud risk in a bond, it just acts as an extra layer of protection.

Best Investment Strategy for Bonds

While bonds are called fixed income instruments, they are not an alternative to fixed deposits or debt funds. Bonds compliment your investment portfolio and diversify your investment.

And it is recommended to hold a diverse portfolio so that ultimately, your investment risk is mitigated substantially. Investing in different assets within the bond spectrum can be a valuable addition to your investment portfolio.

Wrapping it Up

Understand every aspect of your investment, including where it goes and what the risks are is extremely important!

Make sure you know everything about the avenue you are investing in and read the documents before you jump into the investment. The transparency you gauge, will guide you make better financial choices.

And remember, every investment involves a certain amount of risk. Only, the degree of risk changes.

Happy Winting!

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