Saturday, October 20, 2007

Risks in Bond Investment

Despites its conservative nature, Bond investment has risk too. As an investor. you should be aware of the degree of risks you carry in order to invest prudently.

Bonds can be subject to credit risk. This is the risk of default which means that the issuer is unable to pay the interest or the principal of the bonds to the investor. Hence it is important that you find out the credit rating of those corporations that you intend to invest in. You may refer to rating agencies like Moody's and Standard and Poor's to determine the credit worthiness of corporations and governments. Government Bonds are fully backed by the full faith and credit of the government. As such, the risk of default can be little or negligible

It is not necessary to hold bonds till maturity. There is a secondary market where bonds can be sold before it matures. However, you will be subject to interest rate risk if you do so. As you have learnt in the earlier post, bond price can fluctuate due to changes in interest rate. In fact, a bond price has an inverse relationship with interest rate. This means that if interest rate rises, bond price will decline and vice versa. If you were to sell a bond before it matures and the price has fallen, a part of the prinicpal investment would be lost together with any future income stream. Generally, bond investors are more concerned with receiving income instead of capital appreciation, and principal investment at maturity.

Due to its safe and stable nature, returns from bonds are generally lower than high risk investment like equity. In an inflationary environment, the total return may not keep pace with inflation. Hence you may be subject to inflation risk. This means that though the return is postive, you may actually see a decline in investment in real term.

Lesson to be learnt:

Never put all your eggs in one basket. No one investment is totally safe and that includes fixed deposit because you would not be able to hedge against inflation. Diversification is the way to go to grow your money.

Other Topics:

How to set Goals? Click Begin with an end in mind,

Importance of Saving: Click Power of Compounding, Power of Saving,

How to grow my wealth? Ways to Invest