Risks Involved in Bonds Investment
What do we understand by bonds investment risk? You must have thought that bonds are the safest thing in the world. How can there be risks in bonds? In reality, there are several risks in bonds investment too. When bond interest rates go up, it is a major risk. Similarly, high yield bonds may also be junk bonds with low credit quality and there is default risk.
There are also risks in the case of convertible bonds as the price of conversion may turn out unfavourable to you. Even if you invest in bonds through debt funds, these debt fund returns are subject to a variety of risks. Here we look at the entire gamut of bonds investment risk and how these risks impact your bond portfolio and overall portfolio risk.
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Table of Content
1. Price risk or interest rate risk
If you don’t understand price risk, then you don’t understand bonds. The basic rule in bonds is that there is an inverse relationship between bond yields and bond prices. That means; if interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. That is what interest rate risk is all about. It refers to change in bond price in response to a change in the interest rates. Normally, interest rate risk arises when rates go up since that would lead to depreciation in bond values and require MTM write-off. It is also called price risk or market risk and is higher for longer term bonds.
Why does interest rate risk arise? Say you bought an 8% bond at a price of Rs100. After you bought the bond, the interest rates have gone up by 200 basis points. Now, nobody will be interested in buying the 8% bond in the market since fresh bonds are offering 10% return. To compensate for that, the price of the Rs100 bond will come down in the market to Rs98.18, so that the 10% yields are still protected to make the bonds attractive. Price risk is elevated in long-term bonds and even government bonds are subject to interest rate risk or price risk or market risk.
2. Default and Credit Risk
Government bonds don’t default but private bonds can default and have also defaulted in the past. We have seen that in the case of RCOM bonds, Future group bonds and many more such cases. That is credit risk or default risk. As the name suggests, it means the issuer either goes bankrupt or does not have the cash flows to repay the bonds. It is like lending money and not getting it back. While central government bonds don’t default, there have been default by states and municipalities.
The only hedge against credit risk is the credit rating. A high quality bond issue has a AAA rating, which shows that the probability of default is very low. However, in A rated bonds, the default risk can be high, although yields are also quite attractive.
3. Call risk on bonds
Call risk arises due to the call option given to the issuer wherein they can choose to repay the bonds at a future date. This happens when the interest rates have fallen sharply since the issue. When bonds are called back, you get back your principal, but it is a risk because you may be relying on the high returns on these bonds to meet future liabilities. That is not going to be possible any longer. In India, this happened in the case of bonds issued by IFCI and IDBI in the late 1990s, when interest rates were extremely high. In early 2000s when interest rates dropped sharply, the companies realized they were paying yields that were too high. They exercised their call options, leaving many investors in the lurch.
4. Duration risk in bonds
People often confuse duration and tenure of the bond. Normally, the duration is less than the tenure of the bond. That is because, the duration calculates the payback period of the bond in terms of all interim payments. Duration is also expressed in number of years. Let us understand why duration is important for 2 reasons. Firstly, longer the duration, higher is the interest rate risk. You find the long duration bonds suffering the most in terms of price depletion when interest rates rise. The second reason is the matching risk. When you have a long term liability after a fixed period, you should match the time of repayment with the duration of the bond not the maturity of the bond. That eliminates price risk.
5. Reinvestment Risk
The reinvestment risk is often the most important but least understood risk in bonds. Let us take the example of a bond with face value Rs1,000 and coupon of 8%. Each year you get Rs80 as the interest on the bonds. You probably take the money and spend it. That is the problem. When the YTM of a bond is shown to you, it is assumed that these interest earnings are reinvested at the same rate as the YTM of the bond. If that does not happen, then your actual YTM would be much lower than the stated YTM. The reinvestment risk is that the intermediate cash flows are reinvested at a lower rate of return than the YTM.
Is it possible to eliminate reinvestment risk. The one type of bond with zero reinvestment risk is the deep discount bond. Here the intermediate interest is not paid out, but instead assumed to be reinvested in the bond at the stated YTM. That is why, in the case of deep discount or zero coupon bonds, the reinvestment risk is zero.
6. Inflation risk in bonds
Inflation risk is the risk that the yield on a bond will not keep pace with purchasing power. For instance, if your bond pays 9% and the inflation is 4%, then your real returns are 5% (net of inflation). However, in the meantime if the inflation goes up from 4% to 6%, then the real return on the bond comes down from 5% to 3%. That is inflation risk since the same bond is generating much lower in real terms. This can be overcome with inflation adjusted bond, but you don’t have too many available in India.
7. Liquidity risk of bonds
Liquidity risk is the risk that you may not be easily able to find a buyer for a bond that you need to sell. In India, government bonds are quite liquid and it is not a problem to find a buyer. However, most of the other corporate bonds are low on liquidity and if you want to sell a large quantity, you have to either find a block buyer or be ready for a price cut.
8. Macro event risk in bonds
Event risks to bonds can come from a variety of sources. For instance, bond prices can fall if the company gets too leveraged. Mergers and acquisitions can also create event risk for the bonds at a micro level. Credit rating downgrades have become a major event risk in recent times. Then there are macro risks like spike in global inflation, spike in energy prices, geopolitical risk etc.
The moral of the story is that bonds are not just about safety and returns, but also about risks involved.