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Highlights
- A stock market is not the only option for investors to create wealth as they can also tap the debt market.
- However, it’s also critical to be completely aware of dynamics of the debt market.
- It’s also important to know about the risks associated with the bond market.
A stock market is not the only option for investors to create wealth, they can also tap the debt market and earn returns from bonds. However, it’s also critical to be completely aware of dynamics of the debt market. It’s also important to know about the risks associated with the bond market.
Here are the three bond market risks that the investors should know:
Interest rate risk
Bonds are debt market financial instruments which offer fixed interest rates at periodic intervals and are redeemable at a specific time period. These are issued by either the government or some private entity to raise funds for business purposes.
Interest rate defines the attractiveness of bonds. The investor who purchased a bond from a market for a particular price had basically agreed to receive a fixed rate of interest.
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The price of a bond would decline if the interest rate in the market rises since the interest rate being offered would not be attractive anymore and vice versa. Thus, interest rate risk is the risk of bond price falling after the debt paper has been purchased on account of a rise in interest rates in the market.
Default risk
Credit rating agencies generally rate bonds. Depending on the ratings, investors decided if they should buy specific bonds or not. Ratings generally indicate the entity’s principal along with interest to investors. However, there could be chances that the entity may not be able to repay its contractual obligations on time. Such a risk is known as default risk.
It is also critical to check if the debt is backed by a reputed and fundamentally strong business group or not. Private sector bonds are subject to default risk compared to government-backed bonds.
Reinvestment risk
Reinvestment risk is a financial risk associated with the possibility of investing a bond's cash flows at a rate lower than the expected rate of return assumed at the time of buying the bond. For instance, you’d invested in a debt paper that paid 6% annual interest for a 10-year period. On maturity, you decided to reinvest the proceeds. However, the rate of interest now has fallen to 4%. Thus, it is what is known as reinvestment risk.
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