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What are the risks associated with investing in bonds?
Whilst bonds are less risky as an investment as compared to equities, they also have certain risks inherent in them. Below are important risk factors that investors must be aware of while investing:
i. Interest Rate Risk - As bond prices move inversely with respect to interest rates, rising interest rates can cause bonds to fall. Thus, a bond investor will see bonds lose value in a period of rising interest rates. In particular, high duration bonds like investment grade bonds witness the largest losses during a rising rate environment. The price changes seen in 2022 is one such example (see chart below).
ii. Inflation Risk - Higher inflation tends to see central banks raise rates to curtail the existing high demand and attract savings. Thus, rising interest rates due to inflation leads to a bond’s price losing value.
iii. Credit/Default Risk - Bonds carry the risk of an issuer defaulting i.e., not being able to make pay coupons and/or the principal amount. This would mainly occur due to insufficient financial resources on part of the issuer.
iv. Liquidity Risk - In secondary markets, bonds are traded over the counter (OTC) and not as frequently as stocks due to their large ticket sizes. Thus, they tend to have lower liquidity. Also, the most recently issued bonds known as on-the-run bonds tend to have more liquidity than older bonds of the same issuer (off-the-run bonds).
v. Optionality Risk - For bonds with a call option, there is a risk that the issuer may not exercise the call option on the call date. This leaves the investor with an unredeemed bond and extends the duration of the investment.
vi. Reinvestment Risk – This refers to the probability that an investor may be able to reinvest the bond’s cashflows i.e., coupons at a rate equal to the bond’s current yield. The yield to maturity (YTM) of a bond at the time of the original investment has an inherent assumption - that the coupons received from the bond are reinvested at the same YTM. However, if interest rates decrease during the life of the bond, then the final yield on the investment automatically reduces.
While these are the primary risks that exist in bonds, there are others too that may be specific to each bond given their nature and such risks must be considered by reading the bond’s prospectus including cross default, accelerated payments, keepwell risks, trigger event risks etc.
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