The risks related to bonds

12 April 2022
The risks related to bonds

As the market keeps showing its unpredictability in recent times, people have begun considering ‘safe haven’ assets such as FDs, bonds, and gold to secure their investments.

If you too are considering whether this is the right time to add bonds to your portfolio, here are some helpful things to first keep in mind.

Bonds are a form of debt issued by a company or government that wants to raise some cash. In essence, when an entity issues a bond, it asks the buyer or investor for a loan. So when you buy a bond, you're lending the bond issuer money.

While on paper, it might seem like you have a fair idea about the bond you are about to by and its payouts etc, there is always a certain amount of risk also associated with bonds especially those without the backing of the govt. In fact, even govt-issued bonds carry with them a certain level of risk as well.

Listed bonds such as these, present 3 distinct risks- credit, interest rate, and the flexibility of liquidating them.

Understanding interest rate risks

When you buy a bond, you may be aware of its default risk. This is its credit risk, i.e. the risk that the bond-issuer may default on their debt obligations, since there is no collateral or security as with government backed securities.

At Stack we ensure to invest your money only through govt. backed high-rated funds to assume the least credit risk.

Apart from this though they also come with an interest rate risk. This risk will eventually affect how you reinvest and how your money fares against inflation.

Interest rate risk is the potential for a bond's value to fall in the secondary market due to competition from newer bonds at more attractive rates.

Bonds, with the exception of zero-coupon ones, pay periodic coupons which you reinvest. The price of your bond is determined in the secondary market on a number of factors, mainly if they are in demand or not.

While buying, the price at which you acquire the bond might not be as relevant, the interest rate risk, however, creeps up if you are selling at the wrong time.

For instance, if the market is in a rising rate cycle your bond will not compare to the new bonds in the market that offer much more exciting coupons (even with the same type and tenure of the bond). If you time it wrong and sell your bond at this time, you may end up at a loss.

The only way to tackle this is by holding a zero-coupon government security up till its maturity, in this case. This way you avoid both the interest rate risk and reinvestment-related risks as well.

Liquidity risk in bonds

Bonds carry the risk of liquidity with them because you may not have any flexibility with selling them if they are not in demand.

If the volume of transactions on an existing bond is low, that means it does not have enough buyers, and thus liquidity can become an issue for existing customers who wish to sell.

Again, while buying, there is no impact intended by this liquidity risk, but when you wish to sell, the liquidity risk may not only affect the price per bond but may even cause delays in the date of sale, if there aren't enough buyers.

Takeaway

If you are looking to introduce safe assets into your portfolio without disturbing your risk level and the overall composition of your other assets, consider Stack!

By simply selecting your goal and financial objectives, we assess your investing requirements and custom-build a globally diversified portfolio which includes assets such as government bonds and securities, among others.