Introduction
Understanding the balance between risk and reward is essential for making informed investment decisions. Investing in bonds tends to offer a more straightforward relationship between risk and potential returns compared to other investment types. Here, we'll simplify the key risk parameters to consider, helping you navigate your investment choices wisely.
Parameters
For bond investments, while there are multiple types of risk, the two major ones are (a) volatility risk and (b) credit risk or default risk. Volatility risk, also known as market risk or interest rate risk, arises from daily fluctuations in bond yields influenced by economic events. A bond's price and its yield move inversely: if yields decrease, bond prices increase, and vice versa. A bond’s susceptibility to interest rate changes is measured by its modified duration. Simply put, modified duration shows how much a bond's price is likely to change when interest rates move by 1%. The higher a bond’s duration, the more sensitive it is to shifts in yield. As an example, if yield level in the market comes down by 1%, the price of a bond with modified duration of 4 years would move from Rs 100 to 104. For the same yield movement, price of a bond with modified duration of 2 years would move from Rs 100 to Rs 102.
Credit risk, on the other hand, involves the possibility of not receiving scheduled payments, including both interest and principal. This risk is assessed by credit ratings provided by rating agencies, with AAA being the highest, indicating the lowest risk. It is easy for you to gauge; the data on credit rating is available on the bond-related documents as well as on the websites of the rating agencies.
Assessment
On volatility risk, longer the residual (remaining) maturity, higher is the modified duration, hence higher the potential price volatility. It works both ways. For a longer maturity / longer duration bond, when yields come down, you gain more but lose more when yields move up. In a shorter maturity bond, while you gain relatively less when yield come down, you lose relatively less when yields move up.
The bond market often reflects a clearer relationship between risk and reward compared to equities or commodities. Depending on your risk tolerance and investment timeframe, you can select bonds with durations that match your comfort level. At any point, market sentiment—whether bullish or bearish—tends to move bond yields uniformly, though the extent can vary between types, like government versus corporate bonds.
Credit risk, as mentioned earlier, is assessed by the credit rating. However, there is a nuance to it. The yield level on a bond you are buying should be commensurate with the credit risk. The yield should compensate you for the risk you are taking. The nuance is that there is more to credit risk than just the credit rating. Research and analysis teams of institutional investors assess the credit risk of bonds, which is beyond just the credit rating. Yield level in the market, for two corporate bonds of same credit rating, can vary substantially. The differential in yield between two bonds of same credit rating can be say 50 basis points, or in exceptional cases, say upto 1 percent. In the context of bond yields, this is big.
Conclusion
To manage your bond investments effectively, determine the overall risk level you are comfortable with, such as focusing on AAA-rated bonds for lower risk or diversifying with bonds rated from AAA to A for potentially higher returns. Professional fund managers can provide portfolios that align with your risk assessment, offering a combination of security ratings and yield considerations that suit your investment strategy. Always verify the credit ratings and yield projections to ensure they meet your investment criteria.
Disclaimer - Investments in debt securities, municipal debt securities / securitised debt instruments are subject to risks, including delay and/ or default in payment. Read all the offer related documents carefully.