You thought investing in fixed income is risk free? Read on to find out the 7 commonly associated risks while investing in bonds.
The term fixed income is a bit of a misnomer.
It is a common perception that fixed income securities offer safety of returns as compared to equities. While fixed income securities do generally offer more stable returns, they are not entire risk-free. Both the yields they generate and the safety of capital are not ‘fixed’. So, today let us look at the 7 types of risks associated while investing in bonds.
Interest rate risk: This is the most common risk associated with bonds. As we all know, bond prices and interest rates have an inverse relationship. If interest rates are likely to fall, it is advisable to lock in the current yields. On the other hand, if rates are expected to go up in the near future it is better to invest in short duration bonds. The logic is simple. If interest rates increase, investors rush to buy new bonds which offer higher returns by dumping existing bonds. As a result the prices of existing bonds fall.
Reinvestment risk: Investors are exposed to the risk of reinvesting their coupon payments at lower rates if interest rates fall. Say, you invested Rs. 1 lakh in a bond with 14% coupon in 2003; this would fetch you Rs. 14,000 per annum. If you are unable to get the same return (14%) on your interest, i.e. Rs. 14,000 in a falling interest environment, you have faced reinvestment risk.
Call risk: Bonds can also come with a call option which means that the issuers can mature their debt, if interest rates start to decline. For example, in 1992, IDBI had issued deep discount bonds which had a put and call option having a maturity of 25 years with an interest rate 16%. In 2001, the company announced callback of these bonds to retire its high interest costs since it could raise fresh money with lower interest rates. So, if you were an investor in these bonds, your money was returned to you and it would be unlikely that you would enjoy the same returns with equivalent safety.
Inflation risk: It goes without saying that inflation erodes the value of money. If you are earning 9% on a fixed coupon paying bond and the inflation rises from 5% to 6% then then you are earning a real rate of return of just 2.83%. The coupon amount and the principal thus get less in value which means that it loses its purchasing power.
Credit or default risk: Corporate bonds are not completely risk free. Companies raise money from investors to fund their projects but there is no guarantee that they’ll pay back the principal and interest. Credit rating agencies like CRISL and ICRA grade the issues before they are floated in the market. It may just happen that a high credit rated grade may be downgraded if the company’s future performance turns bleak.
Liquidity risk: Lack of liquidity can result in price volatility. The liquidity can be ascertained by seeing the bid ask spread of a bond. Bid is the buy price while ask is the sell price. The higher the difference the more is the security illiquid.
Exchange rates/currency risk: Investors bear interest rate risk if their coupon payments are denominated in a foreign currency, for instance dollar. If the rupee appreciates against the dollar then you earn less.