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Understand the underlying risks before investing in bonds

Understand the underlying risks before investing in bonds
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First Published: Sun, Feb 07 2010. 10 07 PM IST

Updated: Sun, Feb 07 2010. 10 07 PM IST
Bonds are often considered a much safer bet than unpredictable stocks. The general impression is that bonds suit retirees and people looking for a fixed income without losing their sleep. But sometimes bonds can also give you a nightmare.
As a matter of fact, bonds do carry some baggage of their own. In terms of simple market equation, no investment comes without a risk. The best course lies in understanding the underlying risks and pitfalls.
Johnny: I never thought that bonds could also drill a hole in your pocket. Can you explain what the most common bond risks are?
Jinny: Bonds, just like any other investment, are surrounded with myriad kinds of risks, some of which are obvious and some of which are not so obvious.
The first and foremost risk facing any bond is the “default risk”, which in other words represents the possibility of the bond-issuing company not paying back your money. Default could arise in respect of both the principal and interest.
Any company could default in its repayments but you should also keep in mind that in this respect, all companies do not stand on an equal footing. Some companies carry more default risk than the other. Analysts try to estimate the default risk by analysing company’s fundamentals.
To some extent, credit ratings do provide a handy indicator of a company’s ability to serve its debt on time. But credit ratings keep on changing and many times even credit rating agencies fail to fix the bug in time. Change in credit ratings, in fact, represents another kind of risk for the existing shareholders.
Johnny: Another risk? Can you elaborate?
Graphic: Shyamal Banerjee / Mint
Jinny: It involves something called “downgrade risk”. You are in trouble if you are holding bonds of a company and its credit rating gets downgraded. Any rating downgrade has an adverse effect on the current price. So the existing bondholders have two options. They could either decide to sell their bond at the current price by taking some loss or they could decide to hold the bond till maturity and hope for the best.
It seems that the investor has nothing to lose if the company is able to pay back all its dues on the due dates. But here lies a not so obvious loss. You end up assuming extra-risk as foretold by rating downgrade without getting any extra compensation. Those exiting in time, apart from avoiding outright default, also avoid another kind of risk involved with a bond falling out of favour. It’s called “liquidity risk”.
Johnny: It seems all risks are interconnected. Can you explain what this liquidity risk is?
Jinny: Liquidity risk represents the chances of a seller not finding a good number of buyers in the market.
Sometimes the whole market may freeze if sellers are not able to find a buyer at a reasonable price. But many times individual securities might have their own liquidity problems. A company falling from grace may find no takers for its bonds. This could bring problems for an existing bondholder on two fronts: first, he might not be able to get out of the market at his chosen time, and second, the price of a bond having thin trading volumes becomes highly volatile, making it difficult to exit at a reasonable price.
Johnny: Looks like a problem without an obvious solution. What other kinds of risks are associated with bonds?
Jinny: Well, one risk that could affect not just individual securities but the entire bond market is called “interest rate risk”. Every change in interest rate has an inverse relationship with the current price of bonds. So the price of a bond paying 8% interest would fall if the current interest rate is 9% and the price of the bond would rise if the current interest rate is 7%. Why is it so? Bond market follows a simple arithmetic: You pay for what you get. Why would anybody buy a bond paying 8% interest when he could buy another bond of the same quality currently paying 9% interest? As an incentive, a bond paying only 8% interest when the current interest rate is 9% must sell at a discount to its face value. In such a situation, a bond having a face value of Rs100 might fetch only Rs95 in the market.
The discount in face value compensates the new buyer for buying a bond offering lower interest rate compared with current interest rates. The situation is, however, reversed when your bond is paying higher interest rate than the prevailing interest rate. In such a situation, the bond would sell at a premium to its face value.
All in all, change in interest rates would continue to pull the price strings of your bonds either upwards or downwards during its entire tenure. If you manage to cling to your bond till maturity, you would meet another dragon at the gate: something called “re-investment risk”.
Johnny: Enough of bond risks already. We would look at re-investment risk some other time.
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What:A bond faces many kinds of risks such as default risk and interest rate risk, among others
How: Analysts try to gauge company-specific risks through their research of company fundamentals and macroeconomic situations.
Why: It is difficult to analyse the risks associated with a bond portfolio because all risks are interconnected and one event could trigger another
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Feb 07 2010. 10 07 PM IST