Be aware of four risks while investing in debt instruments

Volatility has been the norm for equity markets for some time now. Those who are unable to take the heartburn that comes with the volatility, park their funds in safer debt instruments. But debt too comes with its share of risks.

“Every instrument carries a few inherent risk. No instrument is risk free, not even debt instruments,” Raneet Mudholkar, Chairman and CEO, Financial Planning Standard Board (India) says.

Here are a few risks you should keep in mind while investing in debt.

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Default Risk: “One of the biggest risk you face in debt instruments is default risk. When a company is not able to pay back the maturity as well as the coupon amount, you can face the risk of default,” said Yeshwant Aangne, Mumbai-based, Certified Financial Planner. Debt instruments come with rating from credit rating agencies.

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“Always look at ratings before investing,” Aangne reminds. The higher the rating of an instrument, the lesser is the chance of a default risk. So, a debt instrument with an AAA rating will be a better net than that with a AA rating. Ratings do not guarantee against any future default. However, government securities have no default risk.

Liquidity Risk: “As compared to equity, the secondary debt markets for debt instruments is not very active. So there is a possibility that you may not get buyers for your debt instruments like NCDs,” Aangne says. In a desperate situation, you may be forced to sell your investments at a discount. This is the liquidity risk related to debt investment. FDs, however, are fairly liquid in nature. Most banks today will charge you a penalty for premature withdrawal.

Interest Rate Risk: The best way to tackle this risk is to hold the bond until maturity. Why so? When you hold the bond until maturity, irrespective of the interest rate fluctuations, you get the rate the issuer offered when you had purchased the bond. If you want to sell the bond prematurely, you will have to do it in the secondary market and, the price and yield you get will be that prevailing in the market. It has to be remembered that yield and prices have an inverse correlation. For FDs, however, this risk does not arise, as their interest rates are linked to the market.

Inflation risk: All debt instruments face this risk and you can’t do anything about it. For instance, if you have invested in an FD with 8 percent rate of interest, when inflation is 9 percent, . Tough in a way you are earning 8 per cent, the real rate of return is negative of around 1 percent. For bonds, the longer the tenor of the bond, the higher is your exposure to inflation risk. Apart from the above four types of risks mentioned, there are other risks such as call risk and reinvestment risk.

Call risk is only if the bond you have invested in comes with a call option. When interest rates are expected to fall (the prices are expected to rise), the bond becomes expensive for the issuer. If the bond had a call option, the company can buy the bond back the investor (who is obliged to sell it) after paying off the dues.

“Just because a particular instrument is doing better, it does not mean that you should over expose yourself. Always keep your financial goals on mind and tweak the asset allocation accordingly,” Mudholkar says.

Now that you know about the types of risk, debt instruments face. Keep them in mind while investing and take informed decision