Government bonds are normally referred to as gilt-edged securities. This has two implications. In the old days, the government securities in the US would actually come with a gold edge, which explains the name. But gilt-edged also refers to something that is totally free from risk. The general belief, and wrongly so, is that there is no risk in holding on to government bonds. The truth is that government bonds are only free from default risk. But then bonds are not just about default risk alone. The real risk of bonds lies elsewhere.
So, what are government bond risk and returns? Are there risks of investing in bonds issued by the government? Here are 5 bond investing risks of government bonds that you were probably not aware of.
Inflation risk in bonds..
We all know that inflation is a measure of rise in prices. Inflation is a key macro measure because it measures the reduction in the value of your money. For example if the inflation rate is 10% then Rs.100 today is worth just Rs.90 after 1 year and worth Rs.81 after 2 years. Your money is getting eroded even without your doing anything as the rise in the general price level is eroding your purchasing power. Why is it a risk for government bonds. Let us assume that you are earning 8% on a government bond and the inflation rate is 5%. That means net of inflation you are earning a real return of 3% on the bond. What if inflation goes up to 9% due to a surge in food prices following a bad monsoon? Then your real return is actually (-1%). That means the return on your government bonds is not even sufficient to cover your erosion in purchasing power. Each year your government bond is actually making you poorer in real terms.
Interest rate risk in government bonds..
We are aware that there is a negative relationship between interest rates and bond prices. When rates go up bond prices come down and when rates go down then bond prices go up. That is why bond funds tend to outperform the market when rates are headed downward. But what if rates start increasing? Then the bond prices will start falling and if you are invested in government bond funds then your NAV will start to depreciate. This is called price risk or interest rate risk. In fact, this risk is more pronounced in case of government bonds because these are mostly liquid and long-dated and hence more vulnerable to the price risk.
Reinvestment risk in government bonds…
This is a slightly more complex argument pertaining to the risk of investing in government bonds. When you invest in government bonds then you get interest at periodic intervals and then you get back the face value of the bond at the time of maturity. That is fine but then let us come to the concept of yield to maturity (YTM). When the market quotes the YTM of the bond at 7.5%, there is an implicit assumption in it. The assumption is that your interest receipts are actually reinvested at the same YTM. But if you use up the interest for other purposes then the actual yield on the bond will be lower than the YTM that is claimed. That is the risk of not reinvesting your interest flows at the YTM and is popularly called the reinvestment risk. Most investors in bonds are actually not aware of this risk, but it is a very important risk and needs to be highlighted.
The risk of bear markets in bonds..
Indian bond markets are still closely held and the investors are still banks, insurance companies and large institutions. Hence there is no big risk of a bear market in bonds as in case of other open markets. But globally bond markets have gone through sustained bear markets where investors are just selling out of bonds. The price depreciation due to bond bear markets can be as high as 15-20% in many cases. With FPIs and Mutual Funds investments increasingly becoming important players in the government bond markets, the day may not be far off when bond bear markets could become a genuine risk for the Indian bond markets too. People who typically associate bear markets only with equities need to remember that bear markets can happen to bonds too!
Risk of not taking on sufficient risk
This is popularly called the hidden risk of investing in government bonds. Let us go back to the example of inflation risk in bonds. If you earning (-1%) real returns on your bonds then you are actually destroying wealth over the long run. You would be better off taking a higher degree of risk in equities and facilitating the creation of wealth in the long run. In such cases, the biggest risk of investing in government bonds is the risk of not taking on enough risk when you can actually afford it. The point is that you are taking a big portfolio risk by sticking to government bonds.
More often than not, investors tend to associate risk purely with default risk. While government bonds may be technically free of default risk, there are other more important risks that you need to be familiar with. That gives you a better perspective of government bonds as an investment class!