From interest rate risk to credit risk, here are the risks that can stand between your bond’s promised return and your actual payout.
In the last chapter, Mr. Financewala learnt how a bond’s yield helps in reflecting the true return he can receive from a bond. But in the process of learning this, he had overlooked one of the most fundamental aspects of investing: assessing the risks associated with the investment
As he revisited his shortlisted bond options, he questioned, “Bonds seem stable, but are they really risk-free?”
Curious, he opened his laptop once again, this time to uncover the risks that could potentially impact him.
In this chapter, we break down the key risks involved in bonds, such as interest rate risk, credit risk, reinvestment risk, and more, so you can evaluate bonds with a complete picture.
What Are the Risks in Bonds?
Bonds are seen as a relatively stable investment option when compared to more volatile asset classes like equities, as they provide regular payouts with a defined repayment structure.
However, like any investment, bonds are not completely free of risk. The nature and extent of these risks may vary depending on the issuer, tenure, and market conditions, but they do exist.
Interest Rate Risk in Bonds
As discussed in chapter 4, bond prices and interest rates are inversely related. When interest rates rise, bond prices fall, and when rates fall, bond prices rise.
For instance, suppose Mr. Financewala invests in a bond offering a 9% return. A year later, interest rates rise, and new bonds in the markets are now offering 11%. His bond, which now offers a lower return than the market, becomes less attractive. And if he chooses to sell it before maturity, he may have to do so at a lower price.
Duration and Modified Duration in Bonds
Duration risk is a type of interest rate risk. It measures the extent of how much bond prices move in the event of interest rate change. Interest rate risk also involves how much bond prices move when the rate changes.
Modified Duration is a metric that measures how sensitive a bond’s price is to changes in interest rates, expressed as a percentage change in price for a 1% change in yield. For example, if a bond has a modified duration of 5, a 1% increase in interest rates could lead to an approximate 5% decline in its price.
This is why long-term bonds, which typically have higher duration, tend to react more sharply to interest rate changes compared to short-term bonds.
For Mr. Financewala, this means that two bonds may face the same interest rate movement, but the impact on their prices can be very different depending on their duration.
This makes duration an important concept, especially when investing across different tenures. It helps you understand not just if prices will move, but approximately how much they can move for every 1% shift in market rates.
Credit Risk in Bonds
Credit risk is one of the most widely discussed risks in bond investing. It refers to the possibility that the issuer may fail to make interest payments or repay the principal amount on time.
This risk becomes more relevant in junk bonds (bonds rated below BBB- or Baa3 depending on the rating agency), where yields are higher than those of investment-grade bonds.
For example, a lower-rated bond may offer returns of 14% or higher to attract investors like Mr. Financewala. However, these higher returns come with a higher probability of delayed payments or default. If the issuer faces financial difficulty, there could be delays in coupon or principal payments, or, in extreme cases, the issuer may default on the payments. In contrast, investment-grade bonds may offer returns in the range of 8 to 14%, but with significantly lower default risk.
This is why credit ratings exist. They provide a benchmark for assessing an issuer’s likelihood of meeting its obligations.
Rating Downgrade Risk in Bonds
A rating downgrade occurs when a credit rating agency lowers the issuer’s rating due to weakening financial health. This can reduce investor confidence, leading to a fall in bond prices and an increase in yields, even if there is no immediate default.
Reinvestment Risk in Bonds
Reinvestment risk refers to an investor reinvesting the proceeds from a bond, either through a coupon payout or principal repayment, at a lower rate of return.
This primarily happens when interest rates fall.
For instance, if Mr. Financewala is earning 10% annually from a bond and interest rates drop to 7%, any future reinvestment, whether from coupon payments or maturity, may only fetch 7%. Over time, this can reduce his overall returns.
One way to manage this is through better planning, such as laddering bonds across with different maturities. This ensures that not all funds are exposed to the same reinvestment conditions at once.
Liquidity Risk in Bonds
Liquidity risk is the ability to sell a bond without significantly affecting its price.
While government securities and investment-grade bonds tend to have better liquidity in the secondary markets, some bonds, especially junk bonds, may not have enough buyers and sellers.
To put it simply, if Mr. Financewala holds a junk bond or a less-traded bond and wishes to sell before maturity, he may struggle to sell it quickly or may have to sell it at a discounted price to exit.
Other Risks You Should Know About
While the major risks form the core of bond investing, there are a few additional factors that can also influence outcomes over time.
Sovereign Risk
Sovereign risk refers to the possibility of a government failing to meet its debt obligations. While government bonds are generally considered stable due to sovereign backing, this risk still exists, especially in weaker economies or extreme fiscal situations.
Inflation Risk in Bonds
Inflation risk arises when rising prices erode the purchasing power of fixed interest income. If inflation exceeds the bond’s return, the real return (after inflation) effectively declines, impacting long-term wealth preservation.
Regulatory Risk in Bonds
Regulatory risk refers to changes in laws, taxation policies, or market regulations that can affect bond returns or liquidity. These changes are external and can influence how bonds are issued, traded, or taxed.
Call Risk in Callable Bonds
Call risk exists in callable bonds, where the issuer has the option to repay the bond before maturity. This typically happens when interest rates fall, forcing investors to reinvest their funds at lower rates, impacting overall returns.
Conclusion
With every layer he uncovers, Mr. Financewala’s understanding of bonds becomes sharper. He pulls out a notebook and scribbles down a rough checklist.
Coupon rate (check), YTM (check), Duration (check), Credit rating (check), Liquidity (check), Risk (check).
He caps his pen, looks at the list one more time. He then notices that he hasn’t accounted for the silent partner who has a word to say in every investment he does: tax.
In Chapter 6, we break down how bond returns are taxed in India, because what you earn and what you keep might be two (very) different numbers.
