A Deep Dive into Bond Risk

Bond Risk can be mitigated by being strategic and prudent. 

 

In our last blog, we discussed a few risks associated with Bonds. 

Oh no! You have not read that blog. Here is the throwback. 

Bonds are safe investments. But bonds come with a couple of risks. 

Risks in Bond:   

•    Interest Rate Risk: Risk of changing interest rates
•    Liquidity Risk: Risk of selling bonds for cheap before maturity
•    Default Risk: Risk of not getting invested money back

       To know how to more, click here.

There was a round table meeting with our colleagues. After customaries, a discussion started about our blogs. One of our colleagues was curious to know the next blog topic. Our team said we would be coming up with another blog on “Risk in Bonds.” Techie chuckled. As the bond’s risk is relatively less, he wanted to know the reason for writing another blog on “Risk in Bond.” 

Genuinely bonds are at the base of the Risk pyramid having minimum risk compared to many other securities. But blogging has a vision i.e.

 “Giving complete information about bonds.”

The risk associated with bonds could be relatively less, but information about bonds would be incomplete if we skip this topic. 

Let’s make a deep dive into “Bond Risk.”

Bond Risk Type 1: Reinvestment Risk

You might have earned good returns either by holding bonds till maturity or by selling them before maturity. When you proceed to reinvest this capital, you can run into the risk of getting bonds in the market with lower returns than what you earned previously. This risk is possible if it’s a decreasing interest rate economy. 

Example: Say, you purchased bonds with returns of 10% in an economy by investing Rs 10 Lacs. The bonds mature in the next five years. Every year, you earned Rs 1 lac as interest. At the end of 5 years, you get back any outstanding interest payment and principal amount. Now you want to reinvest your principal amount. 

Now, by this time, let’s say, the average interest rate in the economy has come down to 6%. So, you will be left back with bond options, which will only offer returns around this rate of 6%, which is lower than What you earned in your last investment at 10%.

You can mitigate reinvestment risk by balancing your investment portfolio so that there is a decent gap between the maturity dates of bonds you invest. For this, you can consider having a Bond ladder strategy for your Bond investments. Read here about the bond investment strategy. 

Bond Risk Type 2: Call Risk :

In the case of callable bonds (a callable bond is a type of bond that allows the issuer to redeem the bond before the date of maturity), the bond issuer can buy back the bonds. If interest rates have reduced, then the issuer would like to buy back the present bonds and sell new tranche’ of bonds at a lower rate of interest. This buyback will reduce the issuer’s cost of the debt. But this can happen only with callable bonds and at a predefined date. It means that the investor is told during the purchase of bonds itself that the issuer may buy back the bonds at a predefined date. If the bonds are called back as the issuer feels that current interest rates are lower than previous rates, the bondholder will face reinvestment risk. 

According to your risk appetite, you can maintain the ratio of callable and non-callable bonds in your portfolio. While investing, make sure not too many bonds get matured (or called) in the same period. In investment, being agile is critical, so if one bond gets called, be quick to reinvest in other bonds that can give you the same or better yield. 

Bond Risk Type 3: Inflation Risk: 

As the name suggests, Inflation risk is faced by investors when the value of money decreases. The investor gets the returns as mentioned during the purchase of bonds, but the effective value of returns would have reduced after adjustment for inflation. Inflation is the universal equalizer to all investment options. The impact of inflation can be effectively mitigated by the investor with bond investments rather than equity investments. Another resolution could be opting floating-rate bonds. In floating rate bonds, the bond interest rate is matched to the inflation rate to limit inflation risk on the investor. If inflation rises above a certain predetermined level, the bond interest rates get revised to a higher value.

Example: A  company ABC issues floating-rate bonds at 8% for a tenure of 10 years and adjusts the coupon rate every six months. The coupon rates of the bond are tied to the current inflation rate in the economy (as per the information memorandum published by the issuer for this bond). After every 6 months, the interest rate of the bond will be reset to above 8% if inflation rises. If the inflation rate falls, the bond interest rate will be lowered below 8%. 

You could see here all risks mentioned above can be mitigated by being strategic and prudent. 

That is most of about Risks in bonds, if not all. More than risks, there are many advantages of investing in Bonds. We have also written about 

• Why bonds are better than FDs
• Advantages of investing in bonds

Do read, comment, and share.

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