Diversification is essential for experienced investors. Creating a portfolio that includes a variety of asset classes stocks, currencies, derivatives, commodities, and bonds—is likely the most effective method to achieve consistent returns.
Bonds are regarded as a dependable financial tool, despite the fact that they do not always deliver the highest yields. This is because they are recognised to give consistent income. However, they are also regarded as a safe and trustworthy option to invest your money. That is not to say they are not fraught with danger. As an investor, you should be aware of some of the risks associated with the bond investment. Here are some of the most common dangers.
Interest rate risk
When you purchase a bond, you agree to receive a fixed rate of return (ROR) for a specified period of time. If the market rate rises after the bond is purchased, the bond’s price will decline proportionally. If you sell it in the secondary market, the bond will trade at a discount to reflect the decreased return that the buyer will receive. This is why interest rates and bond prices are considered to have an inverse relationship.
The inverse link between market interest rates and bond prices is true even when interest rates are lowering. Because the coupon payments on the originally issued bond would be more than the coupon payments on freshly issued bonds, the bond would trade at a premium over par value.
Reinvestment risk is another risk linked with the bond market. Reinvestment risk exists when the proceeds of a bond must be reinvested in an asset with a lower yield.
Inflation can diminish the value of bond returns in the same way that it erodes the purchasing power of money. Fixed bonds, which have a fixed interest rate from the start, are most vulnerable to inflation risk.
Floating-rate bonds, also known as floaters, have their interest rates modified on a regular basis to reflect inflation rates, lowering investors’ exposure to inflation risk.
Another danger is that the bond’s issuer will call it. A bond can be issued with a call provision, which permits the issuer to retire it early. The principal is fully repaid, and the interest agreement is terminated.
This is typically done when interest rates have fallen significantly since the issue date. The issuer can retire the old, high-interest-rate bonds and issue new bonds at a lower interest rate.
The risk of a bond’s issuer going bankrupt and being unable to pay its obligations on time, if at all, is known as default risk. If the bond issuer defaults, the investor may lose some or all of the original investment as well as any owing interest.
Default risk refers to the likelihood that the bond issuer may fail to return the principal and interest on time or at all, in which case the investor will have to take legal action. If capital security is your primary concern, invest in bonds with the best credit quality. Bonds issued by central and state governments are guaranteed by the government, therefore there is no chance of default. Bonds produced by corporations entail default risk, but this risk is minimised if you choose bonds with the best credit rating.