Risks Involved in Investing in Bonds

Bonds are one of the most preferred investment instruments for the risk averse investor who wants a decent return on investment (ROI) and capital preservation at the same time. Bonds are debt obligations which pay out a fixed interest on the invested sum and pay back the whole invested principal at maturity. Unfortunately, Bonds are not so straight forward as they might sound. There are many risks involved in investing in Bonds. These risks can cause losses to the investors bond portfolio and defeat the whole purpose of capital preservation.

Some of the risks involved in investing in Bonds are:

1. Interest Rate Risk
2. Re-investment Risk
3. Call Risk
4. Default Risk &
5. Inflation Risk

Interest Rate Risk:

This is the most or well known risk in the bond market. This refers to the risk that bond prices will fall as the interest rates in the market rise. Bond prices are inversely proportional to the prevailing interest rates in the market. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. If the market interest rate rises from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond. The investor would end up suffering losses if he wishes to liquidate his holdings at that point of time.

Market interest rates are a function of several factors such as the demand for, and supply of, money in the economy, the inflation rate, the stage that the business cycle is in as well as the government's monetary and fiscal policies.

Reinvestment Risk

This refers to the risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond. If the investor has chosen reinvestment as an option, he would end up hurting his investment.

Call Risk

This refers to the risk that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs. If an investor has exposure to such callable bonds, the bond issuer can retire the bond and reissue fresh ones, reducing his debt cost, thereby damaging the return prospects for the investor

Default Risk

The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all. This is one of the serious risk factors that need to be considered before investing in a bond. The main aim behind investing in bonds is capital preservation and if you invest in a company that is on the verge of going bankrupt, the investment is as good as flushing it down the drain. To help investors who do not have the time or the means to research into such instruments, Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small, emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investment. Investing in high rating instruments is a wise choice rather than choosing ones with lower ratings. But, there is a catch here, lower rating bonds usually offer higher ROI when compared to the higher rating ones. The Risk-Return trade off comes into picture here. To attract more investors, companies with a lower credit rating usually offer higher interest rates which might tempt the high risk investor to give it a try.

Inflation Risk

The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond and then inflation rises to 10% a year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.

Happy Investing!!!

Investing in Corporate Bonds

The bond market is currently abuzz with scores of investors investing money in millions in it. Before getting into the details let us first find out what a corporate bond is.

A corporate bond is something similar to a bank fixed deposit. The company issuing the bond accepts your deposit and issues you a certificate as proof of your deposit. During the deposit the company agrees to pay you an interest for your deposit. You can opt for periodic interest payments or one lumpsum payment at maturity. All said and done, there are a few major differences here.

1. The interest offered by corporate bonds are higher than that offered by banks
2. There is no guarantee that you would get your money back. The bond is issued on a best effort basis where the company would try its best to repay your money along with interest provided it is able to make sufficient profit.

Now you know why corporations offer a higher interest rate “To attract investors who are ready to take the risk by offering a higher Return on Investment (RoI)”

Why are Corporate Bonds so attractive now?

With the ongoing financial crisis, the equity markets have slumped to nearly half of its peak value at the beginning of the year 2008. Most investors have lost interest/faith in the stock markets and are considering other avenues of investment which can provide them better returns. Currently bonds are one among the top investment options because they offer a better RoI than bank deposits. Though they come with an inherent risk, most corporations that issue bonds are in pretty sound financial status and the chances of losing our principal is comparatively low. Since bonds are like bank deposits your capital remains intact and hence bonds have become attractive now.

The bonds that are currently being issued offer us returns of around 11% which is nearly 2-3% more than what banks offer us.

Though the returns on corporate bonds are high, they come with their inherent risks. Below are some aspects that you need to check before investing your hard earned money in them.

Creditworthiness

Default in payment by the bond issuer is one f the major risks that we face while investing in bonds. The default could range from untimely payment of coupons to non payment of principal at maturity.

The chances of default can be found out by the rating assigned to the bond by authorized agencies on the basis of a rating scale. The higher end of the scale indicates better credit quality which means that the chances of default are lesser. Apart from the chances of default, such agencies also consider another risk before assigning a rating. That is the sector specific risk. If an industry is going through a rough patch due to the prevailing economic scenarios then the chances of the company performing well are lesser. Hence this would naturally affect the company’s finances and eventually affect the bond rating.

It is a general thumb rule to choose bonds with good credit ratings over the ones with not so good ratings.

Risk Return Balance

We should analyze our risk appetite before investing in certain bonds. Some company’s offer very high returns but their credit history wouldn’t be so great. Investing in such bonds should be done with caution.

We can compare the returns on existing bonds with a similar rating in the market to find out the kind of returns that we can expect in new issues. But the yield on a particular bond would also depend on the industry in which the bond issuing company operates. For example the yield on an ‘AAA’ bond in a finance industry would be higher than that of an ‘AAA’ bond in a manufacturing industry. But at the same time, investors would prefer manufacturing industry because of the safety of investment and would prefer them over finance bonds.

We must analyze the performance of the issuing company before making our investment.

Exit Options

One of the most important considerations before buying a bond is the liquidity offered. This is important because most bonds are long term investment options wherein your money would get locked in for 5 – 10 years.

Premature selling of bonds would expose us to interest rate risks. For example, when interest rates go up, new bonds start offering higher rates than that of existing bonds. So at such a situation if you want to sell your bond, you would have to sell it for a lower price than what is its current market value.

Also, some corporations may not be able to pay off the bonds if we plan to exit before maturity. Though these securities are listed in registered exchanges, they may not be liquid and you may not be able to sell them at the current market value. You may have to compromise on the selling price while selling such illiquid securities.

Other factors

Some other factors to be considered before buying such bonds are:

• Do not invest in complex bonds. The simpler they are the better they are for you. For example some bonds give us the option of converting them to that company’s shares. This increases the volatility in price of the bond and it is better to stay away from them.
• Industry situation: Always some industries would outperform its peers and some may underperform. Investing in bonds from industries that are struggling would adversely affect both liquidity and returns on our investments.
• Credibility & Integrity of the Rating agency. Do not just go by the rating given by the rating agency. Analyze the credibility and past history of the agency before believing their rating. Also remember that these ratings are only speculations and do not guarantee the bond performance.

Happy Investing!!!

Bond Glossary

The Bond market is currently abuzz and is attracting heavy investments from investors because of the safety and capital preservation they offer. Bonds are similar to bank deposits with a few minor differences.

Let us have a look at some of the common terms used in the Bond Markets

Convertible Bonds:
These can be converted into the shares of the issuing company at a particular time.

Coupon Rate:
This is the interest received on the principal amount invested by us. It is generally paid half yearly or annually.

Current Yield:
It is the annual rate of return on the bond’s price

Face Value:
This is also called the Par value. This is the maturity amount that the bond issuer agrees to pay the investor

Default Rate:
It is the percentage of companies under a particular rating that have defaulted in making payments to its investors.

Interest Rate Risk:
This is the risk of change in price of the bond due to interest rate fluctuations in the market. Interest rates and bond prices are inversely related.

Yield to Maturity:
This is the rate of return that you get if you hold the bond till maturity. The return includes coupon payments as well as the maturity value. Change in yield reflects change in price of the bond and they are inversely related.

Yield Spread:
This is the difference between the yields of two bonds. Generally a bond’s yield spread is determined by calculating the difference between the bond’s yield and the yield on government securities.

Zero Coupon Bonds:
These are bonds that do not pay any interest. Instead, these bonds are issued at a discount and the difference between the face value and the issue price is the investors gain.


The next article would be on the aspects to be checked before investing in Corporate Bonds.

Happy Investing!!!!!