Types of Risks Involved in Bond Investments
Types of Risks Involved in Bond Investments
Before we get down to learning about the various types of risks involved in bond investments, let us be absolutely clear that risk is something that cannot be avoided but managed. So as an investor, it is crucial for you to understand the risks involved in your investment.
Investing in bonds can help you serve various financial goals. These can be preserving the invested capital, earning a regular income, and balancing risk in your portfolio. However, like any other investment product, it comes with certain risks. These risks can vary depending on the type of bond and the bond issuer.
Let’s understand what these risks are in detail.
1. Interest rate risk
It is the risk that the value of your investment in bonds will go down due to a change in interest rate. Suppose you had invested in a bond which has been paying 7% annual interest. Now, due to an increase in interest rate, a new bond is issued, which pays 8% annual interest. This makes the newly issued bond more attractive to investors, decreasing the demand for and prices of the older bonds.
● Managing interest rate risk
By now, you might be knowing that interest rates changes impact bond prices inversely. To manage this risk you need to measure the degree of this impact. This is called duration. It tells you how much your bond price will change when there is a change in interest rate. Typically, long-term bonds have higher duration than short-term bonds. This means an increase in interest rate will reduce the prices of long-term bonds more than the prices of short-term bonds.
Here’s an example to help you understand this better.
Assume that you have invested in both short-term and long-term bonds. These bonds are paying annual coupons and are having a duration of 1-year and 5-years, respectively. When the interest rate rises, new bonds with higher coupons are issued. So, you might feel underpaid for holding your bonds. The short-term bond will pay you less coupon only once, as there is 1 year left until maturity. On the other hand, the long-term bond will keep paying you less coupon for the next 5-years. This causes the long-term bond prices to decrease more than the short-term bond prices.
As an investor, you can easily manage the interest rate risk by investing in bonds with different duration that matches your future income needs. You can also mitigate the interest rate risk by holding the bond till maturity.
2. Credit risk
A bond is like a loan. When you buy a bond, you give the issuer a loan. The issuer promises to pay you back your principal along with certain interest. But here, you have a risk of the issuer not being able to pay you interest or the principal back. This is called credit risk.
● Managing credit risk
However, as a learned investor, you can easily mitigate this risk by evaluating the creditworthiness of the bond issuer. It is important to choose the degree of risk you can manage. For example, choosing government bonds that are practically risk-free or choosing corporate bonds that might offer more interest. What’s suitable for your risk appetite? Also, even in terms of corporate bonds, you can check the credit ratings of the issuer.
A better credit rating indicates that the bond issuing company is capable of paying the regular interest as well as the principal to the investor when due.
CRAs (Credit Rating Agencies) accumulate all the information about the bond issuing company. This information is then processed by the CRA to give a credit rating to the company. Investing in an informed manner by knowing the creditworthiness of the issuer can ensure that you are taking the risk according to your risk appetite. This way, if you are planning to invest in a bond, you can have plenty of options to choose from.
3. Reinvestment risk
An investment in bonds pays you a fixed interest rate until maturity. That's why it is called a fixed income instrument and considered a relatively safe investment option. But what if the interest rate declines after you have purchased the bond?
If you are looking to reinvest the coupon amount and the principal amount, you will now have to purchase bonds that pay less interest. This is called reinvestment risk. You will however, have no reinvestment risk if you use coupon payments as regular income.
Here’s an example.
Assume that you have purchased a 10-year ₹10,00,000/- govt. bond offering an interest rate of 7.5 per cent. At the end of first year you will receive a coupon payment of ₹75,000/-. Now, imagine that the interest rate has declined to 5 per cent. So, you will have to reinvest your ₹75,000/- in bonds at 5 per cent and earn ₹3,750/-, instead of ₹5,635/-.
● Managing reinvestment risk
You as a bond investor can manage the reinvestment risk by purchasing zero coupon bonds. You can also look to invest in bonds that automatically reinvests the coupon amount into the bond itself. Alternatively, you can manage the reinvestment risk by investing in bonds having different maturity periods. In this way, few bonds will mature when interest rate is low and this can be offset by other bonds maturing when interest rate is high.
To summarise
Investing in bonds can help you earn a regular stream of income while keeping your capital intact (over a duration of your choosing). You have different types of bonds carrying different features depending upon your requirement. Bonds issued by the government and its agencies carry zero risk. Bonds issued by corporations are rated for their safety by SEBI-related agencies and usually pay higher interest rates. As an informed investor, you owe it to yourself to check all this information by looking at the credit ratings of the bond-issuing company.