Risks associated with Fixed Income Securities
Understanding risks in fixed income: Govt bonds offer low returns but low risk; corporate bonds riskier with higher returns. Key risks: interest, credit, liquidity, inflation, exchange rates.
Investors need to understand the risks involved in a fixed-income asset before investing in it. Government bonds are considered risk-free and hence provide a low return on investment, while corporate bonds, being riskier in general, offer higher returns to investors (assuming both are held from issue date to maturity). Entities like public sector undertakings or banks are relatively less risky compared to pure corporate firms, thus providing returns higher than government bonds but lower than corporate papers. Understanding the relative risk involved in fixed-income assets helps investors decide the type of risk they are willing to take. Major risks come from changes in interest rates and the creditworthiness of borrowers. The first group of risk is known as Market Risk, while the second is known as Credit Risk or Default Risk. However, investors can hedge these risks by entering into derivative contracts. Here are a few risks you should be aware of:
Interest Rate Risk
Bonds are subject to risk from interest rate movements. The bond price is inversely related to interest rate movements. If rates rise, bond prices fall. Any bond investment faces two risks—market risk and credit risk. Market risk arises from bond price changes due to market interest rate changes. Additionally, coupons received in the future need to be reinvested at prevailing rates, potentially eroding bond value if rates rise and causing capital loss if sold below purchase price. Conversely, falling rates increase bond prices, boosting overall returns.
Call Risk
Call risk involves a bond being prematurely repaid by the issuer, as permitted in the bond indenture. This usually occurs when a company aims for zero debt or seeks to refinance at lower borrowing costs due to improved credit ratings or market conditions. Call risk makes callable bonds less attractive to investors compared to non-callable bonds, increasing uncertainty. Issuers pay a risk premium for the right to repay debt early when market costs decline. To offset this risk, callable bonds offer higher returns than non-callable ones. If rates fall, issuers can refinance at lower rates, raising bond prices. Investors lose potential gains when bonds are called early.
Reinvestment Risk
Reinvestment risk arises when periodic income from bonds is reinvested at prevailing market rates upon receipt. Higher rates at coupon receipt benefit investors, whereas lower rates reduce reinvestment income. Higher rates relative to coupon rates may lead to capital loss if bond market values decline upon sale. Reinvestment risk is critical for long-term bond holders planning to hold securities to maturity.
Credit Risk
Bonds are debt certificates where issuers promise periodic interest/coupon payments and repayment of principal. Non-governmental corporate bonds rely on issuer credibility for principal repayment. These bonds offer higher yields than risk-free government bonds, reflecting investor risk of capital loss if issuer financials deteriorate. In India, corporate deposits and NCDs offer higher investment rates. Credit risk types include downgrade risk, spread risk, and default risk.
Liquidity Risk
Liquidity risk arises when investors cannot sell assets at need. All investments defer current consumption for future dates. Investors must convert investments to cash without significant loss when needed. Liquid markets absorb asset sales, mitigating investor loss, but illiquid markets force asset sales at lower prices. Long-term bonds pose higher liquidity risk; short-term instruments are more liquid, akin to cash flow timing.
Exchange Rate Risk
Foreign currency bonds expose issuers to currency risk. Issuers acquire foreign currency to fulfil bond obligations, increasing costs if domestic currency depreciates versus bond currency. Currency risk affects bonds issued in foreign currencies by domestic borrowers in international markets. Indian Masala Bonds expose investors to exchange rate risk, where fixed rupee amounts require foreign currency purchases for repatriation.
Inflation Risk
Inflation risk arises when bond returns fail to meet future needs due to unexpected inflation. Stable interest rates underpin investor return assumptions. Rising inflation increases goods costs, reducing real returns despite nominal returns remaining unchanged. Fixed-rate bonds ignore changing conditions; floating-rate and inflation-indexed bonds align with market rate changes, favoured during high expected inflation.
Volatility Risk
Volatility risk affects bonds with embedded options, factoring in option pricing volatility. Plain vanilla bonds avoid interest rate volatility, but credit default swaps against high-volatility investments incur high costs. Low volatility lowers swap costs.
Political or Legal Risk
Tax-advantaged bonds expose investors to political or legal risks. Tax-free bonds become taxable if government rules change, impacting bond prices. Governmental financial constraints delay coupon payments or mandate bond conversion, affecting bond value. Changing repatriation rules impact foreign bond investors.
These risks highlight bond investments. My intent isn't to discourage investing but to raise awareness for managing risks.
f you enjoyed this article, make sure to subscribe to Money Moves for FREE and receive more financial insights straight to your inbox. See you next Sunday at 8:30 am for our next edition!
Very Informative👍👍