Bonds: Are they really a risk – free investment avenue?

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Bonds: Are they really a risk free?
Every portfolio benefits from bonds; they provide a cushion when the stock market hits a rough patch. But avoiding stocks completely could mean your investment won't grow any faster than the rate of inflation. 
 - Suze Orman 
  
I am sure most of you would agree with this and you are right. Bonds are a much safer investment option than equities. However, many of you would be under the impression that investing in bonds protects your money from any kind of risk and there I'll take the liberty to correct you.

Despite being safer than equities and commodities, bonds too carry some risks with them. Let me throw light on a few of them for you!

A bond is a debt security in which the issuer acknowledges debt to the purchaser. Thus, if you are buying a bond, you are lending your money to the issuer of the bond. And, when you are lending your money to somebody, there is a risk that you do not receive it back. In other terms, bonds carry credit risk (risk of default) with them.

To avoid such risk you should look at the credit rating of the bond instrument and only then make a decision to invest in it. Organisations such as CRISIL, ICRA issue ratings for most bond issues.

Another big risk associated with bonds is interest rate risk. You must be wondering, when the interest rate which I get on my bond is fixed, then how can this be a risk? It is not, if you are prepared to hold the bond until its maturity. If you intend to trade it in secondary market, then this is a big risk for you as the price of bond (in the secondary market) has an inverse relation with the prevailing interest rate. Let us assume a scenario. You purchased a bond for Rs. 990 that promises to pay 10% semi - annual interest on face value.

There is now a new bond issue in the market, which offers 12% semi - annual interest on face value. Considering the change in the interest rate, very few people will be ready to purchase the bond, you are holding, that too at a low price as they have now an option to buy a bond that has a higher coupon rate.

Liquidity is another risk faced by bond instruments. If you want to sell your bond in the market, and liquidity is low, then you may find it very difficult to get buyers. As a result, price of your bond will fall. However, this risk does not generally apply to government bonds, as there is always a demand for them.

Bonds are definitely the most suitable investment option for risk - averse or moderate investors. Still, do not ever invest in any bond without looking at all the risks associated with it. For those who do not possess much knowledge regarding bond market, mutual fund is the key.

InvestmentYogi.com

Read more about: bonds, investment, interest rates
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