If you’re interested in creating wealth through market-linked instruments, the stock market isn’t the only option available to you. The bond market is another great investment avenue that you could also consider.
However, before you go ahead and invest in a bond, it is extremely important for you to know the basics of bond investing. Especially the risks associated with investing in them. Yes, you read that right. Contrary to popular opinion, the bond market also has its own risks, though not as much as the equity market.
- What is the risk that you are taking when investing in bonds?
Now that you’re aware that bond risk exists, let’s delve a little deeper into the topic. Here are the risks associated with investing in a bond.
1. Interest rate risk
Bonds are mostly fixed income securities, meaning that they offer a fixed rate of interest throughout their term. Now, when you purchase a bond from the bond market for a specific price, you basically agree to receive a fixed rate of interest.
If the interest rate in the market rises, the bond’s price would fall since the interest rate of the bond won’t be attractive anymore. And if the interest rate in the market falls, the bond’s interest rate would appear more attractive and so its price would also go up.
Interest rate risk is the risk of the bond’s price falling after you purchase it as a result of an increase in the market interest rates.
2. Reinvestment risk
Say that you invested in a bond that pays 8% interest rate for a tenure of 10 years. Upon maturity, you receive the proceeds and choose to invest in a bond again. But by this time, the interest rate has fallen to 6%. This bond risk is what is termed as reinvestment risk.
To put it simply, the risk of not being able to invest the proceeds received from a bond in another bond that pays the same or higher rate of interest is called reinvestment risk.
3. Default risk
Bonds are generally rated by credit agencies. These ratings basically indicate the entity’s ability to repay the principal along with interest to the investors on time. However, despite the ratings, there may be times when the entity is not in a position to repay its contractual obligations on time. The risk of the bond issuing entity not being able to repay its obligations is what is known as default risk.
Conclusion
Now that you’re aware of bond risk, don’t let it dissuade you from investing in them. Despite the risks involved, investing in bonds can all help you create wealth in the long-term. That said, before you invest in a bond, ensure that you’re thorough with the basics of bond investing. This way, you can make informed decisions.
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