5 Risks of Investing in Bonds and How to Hedge Them?
A bond is often considered less risky than stocks or mutual funds. This is because bonds are debt securities usually backed by collateral. That said, there are certain risks of investing in bonds, and it is vital for you to know them and find ways to hedge them. Bond market risks are a culmination of several factors, and this blog will help you navigate them.
Various types of bond risks and ways to overcome them
The major risks with investing in a bond include:
1. Interest rate risk
This is the most common risk associated with bond investment. Bond prices and interest rates are inversely related, i.e., when rates rise, bond prices fall and vice versa. This is because new bonds with higher interest rates make old bonds offering lower rates less attractive.
To hedge against interest rate bond risks, you can consider investing in short-duration bonds. As short-duration bonds mature more quickly, they are less sensitive to interest rate fluctuations. This allows you to reinvest in higher-yield bonds.
2. Credit risk
Credit risk is the risk that emanates from the eventuality of the bond issuer defaulting on interest or principal payments. While government bonds have the lowest credit risk, corporate bonds, especially from low-rated companies carry relatively higher credit risk.
To hedge against credit risk, invest in bonds issued by enterprises that have a higher credit rating (AAA or higher). This lowers the chances of default on the part of the issuer. Another way to hedge against credit risk is to diversify your bond investments across sectors and issuers. This can help you reduce the impact of any single default.
3. Inflation risk
Inflation reduces the purchasing price of money with time and erodes its value. The fixed rate of interest bonds may not keep up with inflation. For example, if you invest in a bond offering 8% interest and inflation is 10% per year, the real value of your bond investment will reduce by 2% each year. Your actual purchasing power from bond returns will come down with time.
To mitigate inflation risk in bonds, consider investing in inflation-indexed bonds inflation risk, you can invest in floating rate or inflation-indexed bonds. These bonds are designed to adjust the interest payment and principal in line with inflation and changes in interest rates.
4. Liquidity risk
Liquidity risk is the risk that you, the investor, will be unable to sell the bond at a fair price due to a lack of market activity. Bonds issued by smaller companies or less-known entities may have fewer buyers, which makes it hard to sell them at a reasonable price.
To mitigate liquidity risk, invest in government bonds or those issued by well-established companies. They have more active markets that allow you to buy or sell them with ease.
5. Reinvestment risk
This risk happens when a bond matures, and you are forced to reinvest the proceeds at a lower interest rate than before. If you do so, you earn lower returns on your investment. This risk is more for bonds that have longer maturities as there are chances of interest rates changing over a longer time horizon.
You can mitigate the risk of reinvestment by laddering your bond portfolio. The laddered approach spreads out maturities over time. This ensures not all bonds mature when prevailing interest rates are low.
Wrapping it up
Though relatively safe, bonds do carry risks that can impact returns. Understanding them and using the right strategies can help lower these risks and ensure the desired outcome from your bond investments.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
