Did You Know | Types of risk that debt instruments carry

Did You Know | Types of risk that debt instruments carry

At a time when equity markets are gyrating wildly, you’d think that debt markets or instruments would be a safe haven. Surely, debt instruments aren’t as risky as equity, but that doesn’t mean they are risk-free. Here are some of the risks that come with debt instruments.

Default risk

When a company is not able to pay back the maturity as well as the coupon (interest) amount, you can face the risk of default. However, sovereign papers are risk-free.

Keep in mind that the higher the rating of an instrument less is the chance of your investment facing a default risk. So a debt instrument with an AAA rating will offer a better protection against default risk compared with a debt instrument of AA rating. Note that the credit rating is a reflection of the company’s past history of debt payment and its present financial situation. Neither does it indicate the kind of returns it is capable of providing in the future, nor does it give a guarantee against future default. But it’s a good indicator.

Interest rate risk

Debt instruments are susceptible to interest rate volatility. There is an inverse relationship between interest rates and bond prices. When interest rates move up, bond prices drop and vice-versa. This volatility affects only those instruments that are listed on the exchange and have a current market price.

If you hold a bond till maturity, then an interest rate hike will not affect your returns. It is only when you sell the bond before maturity that interest rate changes can affect your returns.

Debt instruments such as fixed deposits don’t suffer from interest rate risk as their returns are not linked to the market.

Inflation risk

Inflation plays a cruel joke on debt instruments. Suppose you invest in a debt instrument giving 10% when inflation is 8%. Three years down the line, if inflation rises to, say, 10%, your real rate of return becomes zero. In fact, the longer the tenor of the bond, the higher is the chance that inflation will affect your real rate of return.

Call risk

This refers to the option available in the hands of the issuer, whereby it has the right to buy back the bonds issued to investors before the expiry of the tenor. This is the opposite of put option, where the investor has the option to redeem prematurely. Call and put options get activated after a period as specified in the offer document. Usually, when interest rates are expected to fall down in the future, the present bond becomes expensive for the issuer. The company, in this case, exercises its call option, gives the money back to the investor and may issue a fresh bond at the prevailing lower rate of interest. In this case, you get your principal back. However, all bonds do not come with a call option.