Understanding Biggest Risks of Investing in Bonds & Their Types
If you are looking for investment opportunities that provide fixed returns on your capital, bonds can be a great option. As an investor, you can choose from a variety of bonds available in the market, ranging from public sector bonds, and corporate bonds to central government bonds and state government bonds.
These types of investment products provide assured returns and typically come with a lock-in period. Due to the lock-in period, the liquidity of such instruments is usually low. Investing in bonds however offers a relatively secure channel for regular income.
With that said, it is a common misconception that bonds do not carry any risk. Yes, they are a highly secure form of investment compared to equity or market-linked options. But, as with any investment, bonds are also subject to risk. This article aims to make you aware of these risks of bonds.
What are Bonds?
A bond, prima facie, is a type of loan. Bonds are debt securities wherein the borrower raises money from the investors. Borrowers issue bonds to willing investors for a particular time called the “duration of the bond.” When you purchase a bond, you are lending money to the issuer. The issuer can be a government, a company, or a municipal corporation. In exchange, the entity promises to pay interest dictated by a mutually agreed upon interest rate and repay the principal at maturity. The principal repaid is also called the par value or the face value of the bond.
A critical distinction when comparing bonds and stocks is that, unlike the latter, you do not own any stake in the company or the entity to which you lend money. You will receive an IOU acknowledgement from the issuer. Simply put, you lend money to the borrower for their business expansion or operations. The borrower henceforth is under a legal obligation to repay the amount.
With different entities borrowing money for their respective businesses, the interest rates are subject to a great degree of variation by virtue of several issuer-specific and non-specific factors. Generally, corporate bonds have a higher rate of interest than government bonds, which means the risks of corporate bonds are higher than government bonds.
The main risks of investing in bonds include the following:
In the following segment, let us explore the different types of risks in bonds.
1. Default Risk
When you invest in a bond, you are buying a debt certificate. Many of us are unaware that most of the bonds (except the central/state government bonds) are not guaranteed by the government. Instead, they depend entirely on the issuer’s ability to repay. Such bonds are thus subject to credit risk or default risk. Credit rating agencies determine the creditworthiness of these issuers and help you identify safer investment options.
For example, suppose you invest in a bond with a AAA credit rating. In that case, it implies that the bond has an excellent credit rating, and the risk of default is almost zero. However, if you choose to invest in a bond with a credit rating of C or lower, you expose yourself to a significantly greater degree of default risk.
2. Interest Rate Risk
One thing you should know while investing in bonds is the relationship between interest rates and bond prices. These two are inversely proportional, which implies that if the current interest rate goes down, there will be a rise in the bond prices and vice versa.
Let us look at an example to understand this better. Suppose you invest in a bond that trades at face value and offers a 4% yield. Now, the current interest rate goes up to 5%. Naturally, as an investor, you would tend to sell your existing bond in favour of the one giving a better yield. Extend this behaviour to thousands of investors. There is a considerable influx of bonds offering a 4% yield in the market, with low purchase demand.
Thus, the bond price will go down. On the flip side, when the prevailing interest rate goes down to, say, 3%, you will hold on to your investment, and so will others. However, there is a tremendous demand for bonds with a higher yield; hence, the price of the bond offering 4% yield will go up. And this is precisely what interest rate risk is all about. It revolves around the implied reduction in investment value on account of a surge in interest rates.
3. Reinvestment Risk
Reinvestment risk is the probability that you may not be able to reinvest the income/cash flows received from the investment at a rate comparable to the current interest rate. The new rate is called the reinvestment rate. In simpler terms, reinvestment risk is the chance that the cash flow from an investment will earn less if reinvested. The rate at which the reinvestment of the periodic income is made will influence the total returns from the investment. Let us understand reinvestment risk better with the help of an example.
Consider a scenario wherein you purchase a government bond worth INR 1,00,000 that offers an interest rate of 6% p.a. This implies that you will earn INR 6,000 per year from the investment. Now, at the end of the year, you decide to reinvest the earned INR 6,000. However, the current interest has now come down to 4%. Thus, you will only earn 4% pa from the reinvestment, instead of 6% pa, had the interest rate remained the same. On account of the above-illustrated phenomenon, you are now exposed to reinvestment risk.
4. Liquidity Risk
Most of us want to invest in highly liquid assets and raise cash when required. The liquidity risk arises when there are only a few buyers and sellers in the market. Bonds are exposed to liquidity risk. Unlike the massive demand for government bonds, the market for corporate bonds is still relatively small. This exposes you to liquidity risk, wherein you may not find buyers if you wish to liquidate your bond investment. Furthermore, the inadequacy of demand often leads to adverse price volatility and an implied dip in Investment Value.
5. Call Risk
When you purchase a callable bond, the issuer has the option to call and redeem the security before it matures. Generally, there is a lock-in period before the issuer can exercise the call option. They will not be able to “call” the bonds during that period regardless of any change in interest rates. After the issuer calls the bond, you receive your principal, which typically is at a slight premium to the face value. However, such an option exposes you to call risk. In such a case, you receive the amount but may not be able to reinvest it due to a drop in the interest rates.
Let us understand this through an example. Suppose you purchase a bond with a 5% yield and a ten-year maturity period. The call protection period is four years. After the call protection period ends, the issuer calls the bond as the interest rates drop below 5%. In such a case, even though you will receive your principal at a slight premium, the decline in interest rates will make it difficult to reinvest the amount.
Bonds are considered as a safe investment & also come with some risks which are Default Risk, Interest Rate Risk, Inflation Risk, Reinvestment Risk, Liquidity Risk, and Call Risk. Investors who like to take risks tend to make more money, but they might feel worried when the stock market goes down.
Taking big risks can lead to big rewards, but even if you try to be careful, not all your investments will turn out the way you want.
Which types of bonds are better: Corporate bonds or government bonds?
Corporate bonds generally offer a higher coupon rate than government bonds. However, the former is exposed to a greater degree of default risk. The bond company may face bankruptcy or insolvency, leading to a capital loss. Government bonds typically have no such risks attached due to their ability to raise funds through taxes or other means to pay off investors.
Are government bonds entirely free of risk?
Government bonds are amongst the safest investment options available for investment. While no investment is entirely free of any risk, the security offered by a government bond is very high. There is technically no default risk involved with a government bond due to the ability of governments to raise taxes or issue more bonds. Government bonds are however still susceptible to reinvestment and inflation risk.
How do credit rating agencies assign bond ratings?
Bond ratings are representative of the creditworthiness of the government or corporate issues. The credit rating agencies examine the entity by studying all relevant public data and subsequently issue a credit rating as means of summarising & conveying their learnings on the issuer’s ability to honour financial obligations.
What is the biggest risk for bonds?
The biggest risk for bonds is typically considered to be interest rate risk, also known as market risk or price risk. Interest rate risk refers to the potential for the value of a bond to fluctuate in response to changes in prevailing interest rates in the market.
What are the risks of bond prices?
The main risks associated with bond prices are:
1. Interest Rate Risk: Bond prices move inversely to changes in interest rates, causing fluctuations in their value.
2. Credit Risk: Bonds issued by companies or governments with lower creditworthiness are more likely to default, which can lead to loss of principal.
3. Liquidity Risk: Some bonds may be less liquid, making it harder to buy or sell them at desired prices, potentially impacting investment returns.
How to manage bond risk?
Before investing in a bond, always consider the creditworthiness of the company and check the credit rating provided by agencies like CRISIL, ICRA, etc. This will help you to eliminate the risk of default.
Which bond has the highest risk?
High-yield or junk bonds typically carry the highest risk among all types of bonds. These bonds are issued by companies or entities with lower credit ratings or creditworthiness, making them more prone to default.
Are bonds riskier than stocks?
Bonds tend to be less volatile and risky than stocks, and when held to maturity they offer stable and consistent returns.