Types Of Risks In Bond Investing
Investing in bonds can prove to be beneficial for investors who are looking for fixed and stable returns. They also work as a lucrative alternative to equities, which are subject to market volatility.
While a safer investment option when compared to equities, bonds still come with a certain amount of risk. This article will look at the different types of risks associated with bonds and how you can potentially protect yourselves against them.
What Are The Different Types Of Risks Associated With Bonds
Risk 1: Risk of Default
There is always the risk of default associated with a bond. In case of a default, an investor can lose a part or whole of the invested amount and the interest promised.
How To Manage Risk Of Default: An investor must closely assess the issuer and the credit rating before investing in any bond. Here’s a detailed guide to bond credit ratings. Any bond rated BBB and above is rated ‘investment-grade’ and has low chances of default, while anything below that is considered junk bond.
Risk 2: Rating Downgrade
There is also a possibility where the rating of a particular bond is downgraded. This can happen if the issuer’s debt increases, profit margins and cash flow decrease, and market outlook worsens.
How To Manage The Risk Of Rating Downgrade: Ensure that you conduct a regular analysis of the issuer and the asset.
Risk 3: With rise in bond prices, the yield falls
Bond prices and yield are inversely related to each other. This means that when bond prices rise, the yield falls and vice versa. This is essentially because new bonds with higher interest rates will decrease the demand for older bonds, resulting in a fall in their price.
How To Manage The Risk Of Fall Of Yield: To hedge your portfolio against these movements, an investor must consider investing in short-tenure bonds since they are less sensitive to fluctuations in interest rates. At Grip, you can invest in bonds with tenure as short as nine months.
Risk 4: Inflation Risk
A rapid increase in the rate of inflation can have a major impact on the returns. With rising inflation and fixed interest rates, the inflation-adjusted returns from bonds will reduce even if the coupon rate remains the same.
For instance, if your bond yields 6% returns after tax and the inflation is at 7%, your real return becomes negative (-1%).
How To Manage Inflation Risk: In this scenario, an investor must consider investing in shorter-term assets or opt for bonds offering a floating coupon rate.
Risk 5: Reinvestment Risk
Reinvestment risk, in general, refers to the possibility that an investor will be unable to reinvest the income from an investment at the rate comparable to the current rate.
How To Manage Reinvestment Risk: One of the ways to mitigate this risk is to adopt the bond laddering strategy, which entails diversifying your portfolio with bonds maturing at different times.
Risk 6: Liquidity Risk
There is a possibility that an investor may not be able to sell a bond on an immediate basis without a significant impact on the price. This is likely to happen if the bond is issued by lesser-known entities or smaller companies.
How to Manage Liquidity Risk: Invest in bonds issued by known issuers and big companies. They are likely to be in demand and have a high trading volume.
Conclusion
Investing in bonds can help you earn fixed returns while diversifying your portfolio. But they come with certain risks that an investor must be wary of. We at Grip offer secured, rated and regulated deals with varying tenures you can choose from.
Frequently Asked Questions On Risks Associated With Bonds
1. How can I protect my bond portfolio from risks?
To hedge your bond portfolio against risks, diversify across bonds of various tenures, sectors, credit ratings and interest rates.
2. Are government bonds risk-free?
Sovereign bonds from countries with stable economies are considered low-risk. However, they are still subject to all the risks mentioned above. An investor must conduct due research and analysis before investing.
3. What is credit risk?
It is the same as default risk wherein the issuer of a bond is unable to pay the principle or interest.
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Disclaimer: This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip Invest Technologies Private Limited ("Grip") is not registered with SEBI in any capacity and does not advise, encourage, or discourage its users to invest or not invest in any securities. Grip is solely an execution-only platform and does not guarantee or assure any return on investments made by you in any opportunities sourced by Grip and accepts no liability for consequences of any actions taken based on the information provided. Your investment is solely based on your judgement. Investments in debt securities are subject to risks. Read all the offer related documents carefully.
