What are the risks involved in investing in bonds?

Bonds or debt instruments are among the safest investment instruments, especially when compared with the stock market, which can be volatile and unpredictable. Even among debt instruments, the sovereign guarantee makes government bonds an excellent investment vehicle for those close to retirement or building a pension portfolio, where steady returns are preferable to unnecessary risk.

However, when even stuffing hard cash under mattresses to keep it safe is not without risks, it is naïve to assume investing in bonds is entirely risk-free. The point here, though, is that one must be aware of the risks.

Risk of default:

When purchasing a bond, there is always the risk that the issuer may not make the promised interest payments or even pay back the principal or the original investment, also known as the risk of default.

However, one way to safeguard oneself from a possible risk of default is to look at the credit ratings of the bond issuer. Theoretically, the higher the rating, the lower is the risk of default. 

Interest rate risk:

In the debt market, interest rates and bond prices have an inverse relationship. When you purchase a bond, you earn a fixed rate of interest for staying invested. When this instrument trades on the market, if overall interest rates are higher, the price of the bond you’ve purchased trades at a discount to its original face value, indicating a lower return than for an investor holding onto the instrument.

While you continue to earn the same interest rate on your bond instrument, the market indicates a notional loss for you as an investor, also called interest rate risk. The vice versa could also be true.

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