Bonds can be a great tool to earn a fixed income and are widely considered a safe investment, especially when compared with stocks.
But before you invest in a bond, you need to know the basics of bond investing. Especially the risks associated with investing in them.
Earlier, we covered what bonds are and how they work. In this post, let’s explore the types of risks involved in bonds. We will also dive into the credit rating system, a vital tool for evaluating the creditworthiness of bond issuers.
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When the government and corporate raise money by taking loans from institutional and retail investors like us, instead of taking a loan from a bank, it is called a bond.
As an investor, when we lend our money to the government or corporate through bonds, we take up risks similar to what banks take up when they lend us money.
Yes, the bond market also has its own risks, though not as much as the equity market. Here are the most common risks in bonds.
Types of Risks in Bonds
1. Interest Rate Risk
One of the primary risks in the bond market is interest rate risk.
After you buy bonds from the primary market at the bond face value, the bond price keeps changing in the secondary market based on the market interest rate changes. Yes, the bond price changes like the stock’s price in the stock market.
As interest rates fluctuate, bond prices tend to move in the opposite direction. When interest rates rise, existing bonds with lower coupon rates become less attractive, causing their prices to fall. Contrarily, when interest rates decline, bond prices tend to rise.
This risk is relevant for bonds with longer maturities, as their prices are more sensitive to interest rate changes. If you plan to hold the bond till maturity, then changes in interest rate pose little risk to you.
2. Default or Credit Risk
Default or credit risk refers to the risk of the bond issuer defaulting on interest payments or failing to repay the principal amount at maturity. That’s why it is essential to assess the creditworthiness of the issuer before investing in a bond.
Government bonds are considered less risky as they are backed by the government’s ability to tax or print money. Corporate bonds carry higher credit risk, varying depending on the financial health and reputation of the issuing company.
Credit ratings play a significant role in evaluating this risk, as we’ll discuss in more detail later.
3. Inflation Risk
Inflation risk relates to the potential decline of your purchasing power because of rising inflation.
When the inflation rate exceeds the fixed interest payments you earned from bonds, the real return decreases. Let’s say you invested in a 5-year bond with a 7% coupon rate. If the inflation rate during the period was above 7%, your real return would be negative. You are losing money.
This risk is relevant for bonds with long tenures, as inflation can significantly erode the purchasing power of the fixed income received.
4. Liquidity Risk
Like the equity stock market, the bond market is also exposed to liquidity risk. The liquidity risk arises when there are only a few buyers and sellers in the market.
Unlike the massive demand for government bonds, the Indian bond market for corporate bonds is still relatively small. This exposes you to liquidity risk, wherein you may not find buyers if you wish to liquidate your bond investment.
Furthermore, the inadequacy of demand often leads to adverse price volatility and an implied dip in your investment value. If you plan to hold the bond till maturity, then liquidity doesn’t pose much risk to you.
These are some most common risks associated with bonds.
Now, as discussed in default or credit risk, credit ratings play a significant role in evaluating the creditworthiness of the issuer. Let’s understand the credit rating system of bonds.
Credit Rating System of Bonds
When you try to take a loan from banks, they check your credit/CIBIL score. This score helps them evaluate your creditworthiness.
Similarly, to evaluate the creditworthiness of bond issuers, credit rating agencies assign credit ratings to bonds. These agencies, such as CRISIL, ICRA, and CARE in India, assess the financial strength and ability of the issuer to repay its debt obligations.
The credit/CIBIL score we receive is a three-digit score. Ranging from 300 to 900. A score above 750 is considered as good. Having a good credit score helps in quick approval and better interest rates on loans.
Instead of a three-digit score, a letter-based grading system denotes the credit rating given to bond issuers, with each agency having its own rating scale. This grading system helps us to classify whether a bond is investment-grade or non-investment-grade.
1. Investment Grade Ratings
Bonds with high creditworthiness receive investment-grade ratings. These ratings indicate a lower probability of default. They are classified into various categories, such as AAA, AA, A, and BBB.
Government bonds often receive the highest ratings because of their lower credit risk. Corporate bonds can also receive investment-grade ratings if the issuer shows strong financials and stable repayment capacity.
2. Non-Investment Grade Ratings (High Yield or Junk Bonds)
Bonds with lower creditworthiness receive non-investment grade ratings, also known as high-yield or junk bonds. These bonds carry a higher risk of default. They are assigned ratings, such as BB, B, CCC, and below.
High-yield bonds offer higher coupon payments to compensate for the increased risk. Investing in these bonds requires careful consideration and analysis of the issuer’s financial position. Retail investors are often suggested not to invest in a non-investment grade bond.
The credit rating agencies base their evaluations on various factors, including the issuer’s financial statements, industry outlook, repayment history, and market conditions.
Remember, it’s important to note that credit ratings are not foolproof and should not be the sole basis for your investment decisions. Conducting independent research and seeking professional advice is crucial when considering bonds with different credit ratings.
Understanding the credit rating system helps investors make informed decisions based on their risk appetite and investment objectives. Bonds with higher credit ratings provide a higher level of security, and bonds with lower ratings offer potentially higher yields but come with increased risk.
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Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
Wint – What are the risks of bonds? Understanding the Risks of Investing in a Bond
Investopedia – 6 Biggest Bond Risks
Money Control – Understanding Credit Ratings & Its Implications
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.