Bond investments are often seen as safer alternatives to other asset classes such as equities. However, they present unique risks that investors must clearly understand to protect their capital, financial health, and also optimise returns.
With the country’s bond market expanding and retail participation increasing, a crisp understanding of these risks is essential for making well-informed investment decisions.
Five types of risks involved with bond investments
Here are a few risks of investing in bonds:
1. Understanding interest rate risk
Bond prices and interest rates move in an inverse direction. When interest rates jump or rise, bond prices drop as newer issues provide higher yields, and vice versa. This risk is pronounced for those investors who hold long-duration bonds. Strategies to mitigate such risks and challenges include diversification in bond portfolios and favouring shorter-term instruments, which are less sensitive to interest rate changes.
2. Credit risk and default potential
Credit risk is the possibility that the bond issuer fails to pay interest or principal. Government bonds have a low credit risk profile in this regard, i.e., the chances of default are lower as these bonds are sovereign in nature.
Corporate bonds, essentially those issued by lower-rated firms, carry higher default potential. Aspirational investors, hence, must carefully evaluate issuers’ credit ratings and financial stability before making investment decisions. Furthermore, appropriate diversification across issuers and sectors to reduce exposure to any one investment product is also a prudent way to go ahead with bond investments.
3. Inflation risk and erosion of purchasing power
There are instances when inflation outpaces the bond’s interest rate. Such a development erodes real returns and purchasing power. Fixed-coupon bonds are most susceptible to such issues since their payments do not adjust with inflation. To combat these challenges, investors can consider inflation-protected or short-term bonds during inflationary periods to mitigate this risk and also ensure that they make healthy returns.
4. Liquidity risk and marketability
The risks associated with liquidity arise from challenges in selling bonds without impacting prices. The secondary market for many corporate bonds in the nation is still in a developmental phase. Due to this, retail investors face many challenges and price volatility while going ahead with investments in bonds. Taking this into account, opting for higher liquidity bonds or those supported by active market makers is advisable.
Furthermore, it is prudent to take professional advice before investing in any bonds to ensure that the best decision is made according to the financial condition and future goals of an investor.
5. Reinvestment risk from falling interest rates
This takes place when proceeds from maturing bonds must be reinvested at lower interest rates, bringing down future income. Callable bonds, i.e., bonds that give the issuer (not the investor) the right to redeem, such bonds pose an additional risk as issuers may redeem them earlier if rates drop. Such a development can force reinvestment at less favourable yields. Staggering maturities in bond portfolios can assist in offsetting this risk.
Key risks at a glance
| Risk type | Description | Impact on investor | Mitigation strategies |
|---|---|---|---|
| Interest rate risk | Bond prices fall when rates rise | Decline in bond prices and portfolio value | Diversify bond durations; prefer shorter-term bonds |
| Credit risk | Issuer may default on payments | Loss of principal or interest payments | Assess credit ratings; diversify issuers |
| Inflation risk | Inflation erodes real returns | Reduced purchasing power | Invest in inflation-protected or short-term bonds |
| Liquidity risk | Difficulty in selling bonds without price impact | Potential trouble exiting positions; price volatility | Choose liquid bonds; prefer active markets |
| Reinvestment risk | Maturity proceeds reinvested at lower yields | Lower future income | Stagger maturities; avoid over-concentration in callable bonds |
Note: The above risks are illustrative and may vary depending on the bond type and market conditions. Investors should carefully assess their financial goals and consult certified experts before making bond investment decisions.
The bond market in the nation continues to evolve rapidly, with increased regulatory insights, technology, and deeper scrutiny. Advancing digital platforms have resulted in the broader availability of bonds for retail investors and traders. That is why, for investors, understanding these risks and employing balanced strategies will be extremely important as bonds become central to diversified portfolios.
Disclaimer: The information provided above is for educational purposes only and should not be construed as financial or investment advice. Investors are advised to consult a certified financial advisor and assess their risk appetite before making any bond investment decisions.