Are Bonds Risk-Free?

Bonds (both corporate and government) are widely perceived by retail investors to be "risk free". Although it's true that most bonds are less risky than most stocks, investors should understand that bond investing is not entirely risk free! Here are the top few risks associated with bonds - de-jargonised!

Credit Risk
Credit Risk or Default Risk arises from the possibility that the bond issuer may not pay back the principal and/or interest due in a timely manner. Companies that are heavily debt laden carry higher degrees of credit risk. It would be wise to study the health of the bond issuer before purchasing their bonds - do not blindly buy bonds that offer higher interest rates! A number of debt laden real estate companies have been routinely issuing bonds are 13-16% interest rates. Whether or not their financial health will actually allow them to repay investors in a timely manner is highly questionable.

Credit Rating agencies classify or rate bonds based on the creditworthiness of the issuing companies. Should you blindly trust these ratings? I suggest you watch Academy Award Nominated "The Big Short" before you decide! The recent Amtek Auto 800 Cr default saga (in which credit rating agencies downgraded the bond from as high as "A+" to as low as "C" just prior to its default) is a classic case of bolting the door after the horse has fled. Not very useful!

Interest Rate Risk
Did you know that Bond Prices go up and down too, based on prevailing interest rates that the RBI tweaks from time to time? If you plan to hold the bond until maturity, this shouldn't bother you. But if you plan to sell the bond prior to maturity (or you have invested in a Bond Mutual Fund in which the portfolio gets 'marked to market' daily), you may take a hit if interest rates go up after you invest. Here's the simple logic - if you hold a Bond that pays an 8% interest and rates go up, comparable bonds will now pay a higher interest (say 9%). Suddenly your bond isn't quite that hot anymore, resulting in a natural fall in its price. Fortunately, the reverse applies too - so bond "traders" should pray for interest rates to fall rather than rise!

Inflation Risk
This one's probably the easiest to understand, as the effect is so real! You buy a bond that gives you a post-tax return of 7%, and inflation is 8% that year. The net result is a drop of 1% in your purchasing power. In India, this is a very real risk associated with Bond investing.

Re-Investment Risk
This is the risk that interest rates will change dramatically by the time your bond matures or is repaid, resulting in your having to re-invest the proceeds at a much lower rate. This risk is further exacerbated by the "callable" feature present in some bonds, which allow the issuer to pay you back your principal midway. Understandably, this feature is usually exercised after interest rates fall, so that the borrower (bond issuer) can reduce their own interest burden. The result - you're left with a pile of cash that you'll have to re-invest at a lower rate.

Sovereign Risk
If the entire economy of a country collapses or nears a tipping point, all bonds (and stocks!) of that country will take a hit because investors will start dumping them like hot potatoes! This happened in Greece quite recently, resulting in bond holders booking big losses. This is called "Sovereign Risk".

The Bottom Line
Bond Investing can be trickier than you think. Stick with government bonds (preferably tax free) or bonds of reputed companies. Bond Funds with long term performance track records are a good idea too. Avoid "junk" debt. Don't go 100% into bonds, but use them wisely as part of a judiciously planned asset allocation.

Good luck!