Interest Rate Risk :

Interest Rates have an inverse relationship with Bonds pricing. At the time of purchase, the investor gives the money in lieu of coupon payments at a fixed rate of interest. However if the market rate rises from the time of the purchase of the bond, it effectively means the investor has invested in a bond which now pays a lesser interest rate differential than it used to at the time of purchase. Because of this, the demand for the bond will go down as investors would prefer investing in securities providing better returns, hence the price of the bond will fall. The bond will then trade at a discount to reflect the lower return that an investor will make on the bond.

To understand it mathematically, let's understand the bond price equation:

If,

P = Price of the bond

Cn = Coupon at time 'n' (years, months, etc)

and r = prevalent market interest rate

then, P = C0/(1+r)0+C1/(1+r)1+...+Cn/(1+r)n

As seen in the equation, P (price) and r(rate of interest) have an inverse relation with each other. If r increases, P will decrease and vice versa.

As seen in the equation, P (price) and r(rate of interest) have an inverse relation with each other. If r increases, P will decrease and vice versa.

Reinvestment Risk :

Reinvestment risk is another major risk factor associated with investing in the bond market. It's a risk associated with the category of bonds called 'callable bonds'. A 'callable bond' gives the issuer a right to redeem the bond before the maturity date. The issuer may choose to do it if the interest rates decline. If that happens, the bondholder may have to reinvest cash flows at a lower rate of return. This is called reinvestment risk.

For eg: If a Company's bonds are callable, and market interest rate falls from 10% to 3%, The company will most likely recall the 10% bonds and issue new bonds with a lower coupon. The holders of the 10% bonds would receive their principal back with a small premium, but they would then have to find other investments, which would pay the same rate of return that the company would, which would be difficult in a scenario where rates fall.

Inflation Risk:

Inflation can be detrimental to investors in fixed-income securities because their coupon rate is fixed, while inflation rate keeps changing. When the bondholders purchase a bond, the issuer commits to paying a certain coupon rate until the maturity date of the bond. However, if the inflation rate goes beyond the coupon rate, then it effectively erodes the invested amount.

For example, if you invest in a bond that pays 5% p.a. coupon every year but the inflation reaches to 6% p.a., then it effectively means that the bond is eroding your investment at 1% p.a.

Default Risk:

The default risk attached to investing in a bond is often inevitable, but can be mitigated with proper research and by investing in a creditworthy bond. When an investor purchases bonds, in principle they are loaning money to the bond issuer - implying that the money has to be returned to them, in the manner that is pre decided. This happens in the way of timely payment of coupons and principal payment at the time of maturity by the issuer to the bondholder. And just like the risk that all loans carry with themselves, bonds too, come with the same. If the issuer, for whatever reason is unable to make timely payments or the principal payment that means that they have defaulted, causing the investor a loss. Given the volatile nature of the markets, defaulting is a possibility, which is why an investor must be guided properly before they decide to invest in a particular bond.

Ratings Downgrade Risk:

What this risk entails is the possibility of the bond you invested in, being demoted from its previously held grade - that initially led you to invest in it. Credit rating agencies keep the bond issuers under constant scrutiny. The market forces which sometimes lead to their credit ratings to be either upped, or marked down, depending on their performances. The grade a bond is awarded massively impacts how the market also treats them. If their credit rating is low, then their capacity to access funds is negatively affected. For example, if the issuer has been demoted from an AAA rating to an A rating, other lenders will now lend to them, at a higher interest rate which only further hurt their ability to repay existing loans - in turn, hurting investors. This also means that all the future bonds that the issuer may offer will suffer owing to the reduced demand, which will also reflect in the reduced value of the bond. Ratings downgrade risk, directly impacts the issuer's ability to repay its existing investors.

Liquidity Risk:

What often happens when one invests in a bond, there is an inherent liquidity risk the bond may carry in the secondary market. Owing to the thin market, investors may find it difficult to sell their bonds in the secondary market at the price they expect. This leads to liquidity risk. It implies that the market doesn't have as many buyers willing to purchase bonds at the price expected by the sellers.

Investors will sometimes find it difficult to sell corporate bonds, as opposed to government bonds, because the takers for a safer investment are higher, than for corporate bonds. This often leads investors scaling back on their asking price, offering to sell their bonds at a much lower price, than what they bought it at.

While bonds are considered relatively safe instruments of investments, nothing in the market is realistically risk free, and bonds too come with their own set of limitations. However, a prudent investor can be made from researching, doing their due diligence and with the correct guidance. BondsKart believes in transparency and efficacy, giving investors the confidence to invest in bonds without confusion or deception. All our listed bonds come with performance details that help investors understand all the risks associated with it, in an attempt to slim down the possibilities of a surprise risk. You can find everything you need to know, here.