Navigating the Risks of Bond Investing

Mr. Mahesh had always been wary of bond investing. He had heard stories of investors losing money in bond investments because the company defaulted, and the thought of taking such risks made him very anxious. For years, he avoided any investment opportunity that involved bonds, even though his financial advisor tried to explain the benefits of diversifying his portfolio with fixed-income investments. One day, he came across a great opportunity to invest in a bond issued by a well-established company. The bond had a high yield and a solid credit rating, which meant that the investment was relatively safe. However, Mr. Mahesh was still hesitant and decided not to invest. Several months after, the RBI reduced interest rates, causing a surge in bond prices. Mr. Mahesh watched with regret as his friends who had invested in the same bond celebrated their profits. He realized that he had missed a great opportunity because of his fear of taking risks.

A bond is a fixed-income security representing a loan from an investor to a borrower, with a fixed interest rate and a promise to pay back the principal amount at maturity. Investing in bonds can diversify a portfolio and generate income, but it’s crucial to understand the bond investment risks, including the potential for default, inflation, market fluctuations, etc. Hence, investors must contemplate what are the risks associated with investment in bonds and assess whether the potential returns align with their investment objectives and risk tolerance.

Types of bond risks:

Interest rate risk:

Interest rate risk is a type of risk associated with bond investing that arises from the possibility that changes in interest rates may impact the value of the bond. Bond prices decrease when interest rates increase and conversely, bond prices increase when interest rates decrease. For example, suppose you buy a bond with a fixed coupon rate of 10% per year for 5 years. If the repo rate hikes to 50 bps during that time, new bonds with a higher coupon rate would be more attractive to investors, and the value of your bond may decrease. Bonds with longer maturities typically have greater interest rate risk than bonds with shorter maturities. One can hedge against this by having floating rate bonds in their portfolio which pay higher coupons when rates rise.

Credit risk:

The possibility that the issuer of the bond may default on its debt obligations or become insolvent is known as credit risk. When an issuer defaults on its debt obligations, it may not be able to repay the principal amount of the bond, causing a loss of principal for the bondholder. Credit risk is typically assessed by credit rating agencies, which assign credit ratings to bond issuers based on their creditworthiness. Bonds issued by issuers with lower credit ratings are generally considered to have higher credit risk, as these issuers may be more likely to default on their debt obligations. Investors can manage credit risk by diversifying their bond investments across different issuers and industries, and by selecting bonds with credit ratings that match their risk tolerance. Also important that as most bonds are secured, investors can still recover some of their principal back as recovery in case of default.

Inflation risk:

Inflation affects the purchasing power of an investor’s returns. It erodes the value of money over time, causing the cost of goods and services to increase. This can have a significant impact on bond investments because the fixed rate of interest paid by bonds may not keep up with inflation. For example, if you invest in a bond that pays a fixed rate of 8% per year and inflation is at 9% per year, the real value of your returns will decrease by 1% each year. This means that while the nominal value of the bond may remain constant, the actual purchasing power of the returns will decrease over time. To mitigate inflation risk, investors may consider investing in floating rate bonds or inflation-indexed bonds. These bonds are designed to adjust their interest payments and principal value in line with inflation and change in interest rates, helping to maintain the purchasing power of the returns.

Liquidity risk:

Liquidity risk in bond investing refers to the risk that an investor may be unable to buy or sell a bond at a desired price due to a lack of market activity or depth. This can result in difficulty or delay in converting the bond to cash or incurring a loss if the bond must be sold quickly. Liquidity risk can be affected by factors such as the trading volume of a particular bond, the size of the bond issue, credit rating and the overall demand for the bond in the market. For example, a bond issued by a smaller company or with a less frequent trading volume may be more difficult to sell than a bond issued by a larger company with a more active market.

Reinvestment Risk:

Reinvestment risk is the risk that the cash flows from a bond investment will be reinvested at a lower rate of return than the original investment. The risk arises from the fact that when a bond matures or pays off, the investor must then reinvest the proceeds at the prevailing market interest rates, which may be higher or lower than the rate on the original bond. If interest rates have fallen since the original bond was purchased, the investor may have to reinvest the proceeds at a lower rate, resulting in a lower overall return on investment. Reinvestment risk is particularly relevant for bonds with longer maturities, as the potential for interest rate changes is greater over a longer time horizon. To mitigate this risk, investors may consider diversifying their bond portfolio across different maturities and issuers.

Bonds have always been a go-to option for people who are looking for predictable cash flows. To know more about the benefits of investing in bonds, click here.

Risks are a part of life, and avoiding them altogether can sometimes lead to missed opportunities. Whether it’s investing in the financial markets, trying a new hobby, or even just crossing a street, there’s always a risk involved. However, we shouldn’t let our fear of risks prevent us from living our lives to the fullest. Instead, we should educate ourselves, take calculated risks, and learn from our experiences, both good and bad. Therefore, to understand ‘what is the risk of investing in bonds’, investors should educate themselves and carefully evaluate bond risks to make informed decisions when investing in bonds.

FAQs

Q: How can investors manage these risks?

A: Investors can manage these risks by diversifying their bond portfolio, choosing bonds with higher credit ratings, keeping the bond’s duration in mind, and being aware of the macroeconomic factors that can impact the bond market. Additionally, investors can consider using an online bond platform like IndiaBonds to help understand and manage these risks.

Q: What are the benefits of bond investing?

A: Bond investing provides regular income through interest payments, and bonds are generally considered to be less risky than stocks. Bonds can also diversify a portfolio, reduce volatility, and provide a hedge against inflation.

Q: Which types of bonds are better: Corporate bonds or government bonds?

“Better” depends on what you want your money to do. Government securities (G-Secs) and State Development Loans (SDLs) usually carry lower credit risk and therefore offer relatively lower yields. Corporate bonds, especially Non-Convertible Debentures (NCDs), typically offer higher yields to compensate for higher issuer risk. If stability and liquidity are primary, high-quality sovereign or PSU issuances can fit well. If you’re targeting a higher income and can take measured credit risk, well-researched investment-grade corporate bonds may suit you. Most portfolios blend both to balance income and safety.

Q: Are government bonds entirely free of risk?

No investment is entirely risk-free. G-Secs carry negligible credit risk because they are backed by the sovereign, but their market price can still fluctuate with interest rates (market/interest-rate risk). Longer-maturity G-Secs are more sensitive to rate moves than shorter ones. There’s also reinvestment risk on coupons, and potential liquidity considerations in specific segments of the market. If you hold a G-Sec to maturity, you eliminate price volatility at the end date, but interim mark-to-market swings still matter if you need to sell earlier.

Q: How do credit rating agencies assign bond ratings?

Rating agencies assess the issuer’s ability and willingness to pay interest and principal on time. They typically evaluate business strength, competitive position, cash flows, leverage, coverage ratios, asset quality (for lenders), governance, and external support (e.g., parent or government linkages). The analysis is both quantitative (financial metrics, scenario tests) and qualitative (management quality, industry outlook). The output is a letter grade (e.g., AAA to D) that is monitored and can be upgraded or downgraded if fundamentals change. Remember: a rating is an opinion, not a guarantee.

Q: What is the biggest risk for bonds?

For most individual investors, the most visible risk is interest-rate risk — the inverse relationship between bond prices and market rates. When rates rise, existing bond prices fall; when rates fall, prices rise. If you plan to sell before maturity, this matters. For lower-rated issuers, credit risk (downgrade or default) can be the dominant risk. Which one is “biggest” for you depends on your holding period, the bond’s rating and tenure, and whether you intend to trade or hold to maturity.

Q: What are the risks of bond prices?

Bond prices move primarily with:

• Interest-rate moves: Longer duration = larger price swings for the same rate change.
• Credit events: Downgrades, weak earnings, or adverse news widen spreads and push prices down.
• Liquidity conditions: Thinly traded bonds can show wider bid-ask spreads and sharper gaps.
• Macro and policy shifts: Inflation surprises, RBI policy, or global risk sentiment can reprice yields across the curve.
  These drivers can work together; for example, a weak macro backdrop can hit both spreads and risk

Q: How to manage bond risk?

Start with fit-for-purpose selection. Keep duration aligned to your time horizon (shorter duration if you’ll need funds soon). Diversify across issuers, sectors, and maturities — laddering maturities helps smooth reinvestment and rate risk. Prefer transparent, listed, investment-grade issuances for core allocations; take sub-investment-grade exposure only if you fully understand the credit and can size it prudently. Reinvest coupons thoughtfully, monitor rating actions and covenants, and avoid concentration in a single issuer or structure. If in doubt, err on the side of liquidity and quality.

Q: Which bond has the highest risk?

Generally, long-duration, low-rated (or unrated) corporate bonds carry the highest combined risk — they are sensitive to both interest-rate moves (duration) and issuer-specific stress (credit). Complex structures (e.g., deeply subordinated, perpetual, or with weak covenants) can add to risk even if the headline coupon looks attractive. For most retail investors, such exposures, if taken at all, should be small, well-researched, and balanced by higher-quality holdings.

Disclaimer: Investments in debt securities/ municipal debt securities/ securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully.