WHAT ARE THE RISKS INVOLVED WITH BOND INVESTMENT? Does that mean we should not invest in bonds?

WHAT ARE THE RISKS INVOLVED WITH BOND INVESTMENT?Does that mean we should not invest in bonds?

INTRODUCTION "Successful investing is about managing risk and not avoiding it" - Benjamin Graham.

Though bonds are considered safe, no instrument is devoid of risks.

Risk is an inherent part of any investment; bonds also carry some risk.

However, as compared to other instruments, the bond has lesser risk.

As we can see in the above chart, equity and gold returns have been quite volatile, but debt has provided a relatively stable and steady return.

However, the main focus of an investor is not on avoiding risk but managing it.

WHAT ARE THE RISKS INVOLVED WITH BOND INVESTMENT? If you want to buy different types of bonds such as government bonds, corporate bonds, tax free bonds, zero coupon bonds, PSU bonds, covered bonds etc., there are various online portals like BondsIndia.com, which will show you in simple steps how to invest in bonds.

However, investing in bonds is not risk-free; below are some of the risks involved with a bond investment:

1. CREDIT RISK Credit risk, also known as default risk, is the possibility that the bond's issuer might go bankrupt and will not be able to pay back the principal amount and the remaining interest amount. In that case, investors might lose their hard-earned money.

The credit rating of the bond shows the issuer's creditworthiness. The bond with the highest credit rating is considered the safest and vice versa.

Check also- why to invest in higher rated bonds, invest in A rated bonds, invest in AA rated bonds, invest in AAA rated bonds.

2. INTEREST RATE RISK Investors get a fixed rate of return (coupon) when they buy bonds.

The yield of the bond & the bond's price is inversely related. If the bond's yield decreases, the bond's price will increase, and if the bond's yield increases, the bond's price will fall.

So, if the interest rates increase in the market after an investor buys a bond, the price of the bond will fall, and the investor will get a lower return if he sells that bond in the market. This happens because the current bond will seem unattractive as the new bonds offer a higher interest rate. The opposite happens when the interest rates fall in the market.

Read more- How Fed interest rate impact on Indian Bond Market?

3. REINVESTMENT RISK Investors get a fixed rate of return on their bonds. Many investors invest these cash proceeds (coupon payment) to earn a higher return. However, if the interest rates in the market are lower, they will get a lower return for their proceeds. This is called reinvestment risk.

Suppose an investor earns a 10% coupon on a Rs. 1000 bond. He receives Rs. 100 (1000*10%) as coupon payment, which he can reinvest. If in the market, the interest rate falls to 9.20%, he can reinvest these proceeds at 9.20% instead of the 10% rate of the original bond.

Read - Why to Invest in Higher Rated Bonds Like AAA, AA+ or A in India?

4. INFLATION RISK Inflation risk refers to the risk that the return on the investment doesn't cope with the inflation.

Suppose the investor purchases a fixed-rate bond that offers a 6% return. If inflation reaches 7%, he might lose money on his investment.

Inflation risk will reduce the purchasing power of a bond's future coupons and principal.

See- how to purchase govt bonds online, how to buy tax free bonds and how to invest in zero coupon bonds in India.

5. LIQUIDITY RISK Liquidity risk is the risk that the bondholders will not find a significant buyer, and they will have to sell the bond at a discount to the market value.

6. CALL RISK Call risk is the risk that the issuer will call back the bonds from the bondholders before maturity. The issuer usually does this if the interest rates start falling.

Read also- How to profit from rising interest rates

DOES THAT MEAN WE SHOULD NOT INVEST IN BONDS? Every instrument has some risk attached to it, and it does not mean that investors should not invest in these instruments.

Their primary focus can be on managing the risk.

The two methods through which investors can manage risk are: Diversification - It will help minimise risk as capital is invested in different instruments. If one instrument is not performing well, the other might and vice versa.

Bond laddering - In this method, investors can buy bonds with different maturities, which will reduce the risk of bonds maturing at a time when interest rates are low.

Read - how to invest in bonds in India and why should you invest in bonds

CONCLUSION Investing in bonds is not entirely free of risk; it has some risks, such as inflation risk, credit risk, interest rate risk, etc.

Before making an investment decision, investors need to be aware of these risks.

Investors are recommended to analyse the bond carefully and have good market knowledge.

Assessing one's risk appetite before jumping into bonds investments is essential.

However, even if investors apply techniques to manage the risks, it is difficult to eliminate the risk involved in bonds completely.

One of the best bonds investment sites in India for buying bonds is BondsIndia.