Risks Involved in Investing in Debt

Risk refers to uncertainty in returns. Debt instruments are considered less riskier than Equities because there is a lesser uncertainty in the returns one can expect from Debt Instruments. Never the less, following are the major risks are involved in investing in Debt Securities.

Interest-Rate Risk

Fixed income securities such as bonds, debentures and money market instruments face interest-rate risk. Generally, when interest rates rise, prices of existing fixed income securities fall and when interest rates drop, prices of fixed income securities increase.

For example: If a Rs. 100 par value security offers 9% rate of return, and the prevailing rate of interest increases from 9% to 10%, the values of the security will fall below Rs. 100 because it offers a lower rate of return(9%) compared to the market return(10%). The extent of fall or rise in the prices depends on the existing coupon rate, time to maturity of the security and the quantum of increase or decrease in the interest rates.

Before Investing, be informed of the risks involved…

Credit Risk

In simple terms this means that the issuer of a debenture/bond or a money market instrument may default on interest payment or in paying back the principal amount on maturity. Even if no default occurs, the price of the security may go down if the credit rating of the issuer of the debt instrument goes down.

Investment in Government securities has zero Credit Risk as the Government is not expected to default on its obligations.

Liquidity Risk

This refers to the ease with which a security can be sold at or near to its market value. Liquidity risk can be measured by the difference between the buy price (bid price) and the sell price (offer price) quoted by a dealer. Larger the difference, greater is the Liquidity Risk. Indian Debt market has a higher Liquidity risk compared to Global Debt market, because of low trading volumes in the Indian Debt market.

Reinvestment Risk

If interest rates fall, the coupon payments being received on fixed income securities will have to be re-invested at the lower prevailing interest rate. This is known as Reinvestment Risk.

For example: If you are receiving 9% coupon on a fixed income security, and the prevailing interest rates are 7.5%, the coupon payment received will have to be invested at the lower rate of 7.5%.

As zero coupon securities do not provide any periodic interest payments they do not have Reinvestment risk. However, they have a higher interest rate risk.

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