One can’t be too careful with one’s money during these times of economic downturn. Every investment that you make needs to be evaluated properly. Each investment option has its own share or pros and cons. The higher the risk, the greater the return on investment.
Investments in bonds have usually been considered a relatively safe investment. When you invest in bonds, you essentially invest your money for a fixed duration for an assured return of principal amount on time of maturity. As a return on the investment you are promised a fixed rate of interest. The bonds are usually insured by the issuing body and hence an investor can be at peace knowing for sure that at the time of maturity he will definitely get the returns promised. With their seemingly low risk nature, bonds also yield lower returns as compared to other market instruments.
But it’s not all that simple. Even bonds have certain risks associated with them. Let’s take a look at what they are.
Maturity Risk
Bonds usually assure a guaranteed return on your investment after a fixed duration of time and fixed interest. For regular investors and people who use bonds to manage their savings, the most common thing to do once a bond expires is to re-invest the returns in a new bond. The risk associated is the loss of income during the period of investment due to increase in interest rates. The longer the duration of the bond, the higher the maturity risk. A bond for 10 years poses a higher threat of loss of income, than a 3-year bond, as the possibility of substantial change of interest rate is relatively higher in longer duration
Credit Risk
Treasury bonds are issued by the US treasury. They are a form of debt i.e. you as an investor are issuing a loan to the US Treasury. Hence your return on the bonds is dependent on the credit worthiness of the issuing authority, which in this case is the US treasury. The rate of interest on the bond, the ways the bonds are priced are all dependent on the credit worthiness of the issuing authority. The US Treasury is a very stable financial organization; however, in case of extreme political stability or a worldwide war, your bonds are at a risk of losing value. Bonds are also issued by corporate, and these are called debentures. These usually carry high returns and high risk as compared to treasury bonds. The value of the bond is dependent of the credit rating of the corporate or issuing firm.
Call Option Risk
As an investor you can also invest in a ‘callable’ bond. A callable bond gives the issuing authority to ‘call’ back the bond as of a certain date. This will typically happen when market rates drop. The issuing authority will ‘call’ back the bond and then re-invest the money in new bonds with lower rate of interest. And as an investor there is nothing you can do about it.
In this article, we have covered very specific risks, but there are certain general risks that will apply to bonds as they apply to all other types of investments. These are market risks, which are dependent on the political scenario, government stability, and general economic performance of the country.