The shadow of ‘risk’ lurks everywhere, whether in life or investing. The investment landscape has a large canvas of risk, starting with extremely high-risk investments, such as the unregulated world of cryptocurrency at one end, to safe investments, such as Bonds guaranteed by the sovereign. Somewhere within the spectrum are Equities with high-risk associated and many Debt instruments and Bonds with varying degrees of risk.

Debt instruments, such as Bonds, carry a fair degree of risk. Most fixed-income investors are risk-averse and invest in debt to avoid sudden, unpleasant hits to their portfolios. An investment in a Bond is typically exposed to credit, liquidity, and interest rate risks. Here are the details:

Credit risks

Credit risk is a crucial parameter for bonds, and understanding it is beneficial for every investor wanting to invest in a range of debt instruments. Credit risk simply denotes the possibility of an issuer of a Bond not paying the interest, principal, or both on the due date as per the terms. In India, this has been very evident in the past when some of the issuers failed to honour their commitments to the investors.

Liquidity risks

Liquidity risk is uncertainty about whether to sell instruments when one needs money. Many Bonds are thinly traded and cannot be easily sold to create liquidity.

Interest rate risks

It refers to the impact of changes in the overall interest rate environment on the debt instrument, which has a direct impact on its price. As is evident in recent years, interest rates globally have gradually lowered, followed by the current cycle of central banks worldwide raising interest rates to tame the raging inflation. Liquidity and interest rate risk do not impact investors who intend to invest in Bonds and hold them till maturity.

How does credit rating help?

Credit rating is a mechanism to help investors understand the overall risk level associated with debt offerings. Debt issuers approach credit rating companies to measure the credit risk associated with each bond. In the credit rating agency’s opinion, Corporate Bonds with the highest safety of repayment of principal and interest are AAA-rated.

As the credit risk increases, the rating changes to lower levels such as AA+, AA, A, A+, BBB, etc. A debt instrument assigned a ‘C’ rating carries a very high risk for investors, while a ‘D’ signifies imminent default. Credit rating agencies operate within fixed frameworks, which may sometimes prevent them from accurately assessing the risk. Many institutional lenders and investors have their own credit teams to assess the risk involved and exploit this arbitrage.

Conclusion

Taking the right credit risk can enhance one’s portfolio returns. A relatively low credit rating means the coupon payments are higher than AAA-rated bonds. Thus, an inverse relationship exists here: The higher the rating, the lower the returns.