Risks of investing in Corporate Bonds / NCD / Tax Free bonds
There are several non convertible debentures / Bonds / Tax free bonds, which keep coming to market. Investors always get a question in their mind whether they can subscribe to such NCD / Bonds / Tax free bonds and what are the risks involved in investing in such bonds. These bonds are issued by both Govt enterprises and private corporates. If an investor knows various risks involved by investing in corporate bonds, he / she would be ready before making such investments.
7 Risks of investing in Corporate Bonds
1) Credit Risk / Default risk
This is the risk where a company can default the interest payment as per due date or does not do principal repayment to the bond holder. There are many corporates who float NCD’s, but generally default in payment of interest or repayment of the principal deposit amount. In case there is a lot of delay, one can approach SEBI Redressal cell and lodge a complaint for such delay. However this is the major risk an investor should consider while investing in bonds.
2) Prepayment risk
Many companies adopt the method of prepayment of bonds before maturity. This happens especially when interest rates are going down, bond prices go up. In such case, corporate does prepayment of such bonds before maturity. An investor would loose difference in the face value of the bond Vs bond market price. E.g. Interest rates have gone down, NCD bond prices go up. A bond whose face value is Rs 1,000 might be available at Rs 1,050. However, companies would close the bond and pay Rs 1,000 to the NCD holder before maturity. NCD holder would lose Rs 50 per bond due to such prepayment risk. However, in Indian economy, this happens very rarely.
3) Interest Rate Risk
Interest rate risks highly impacts the prices of the bond. If interest rates go up, bonds which are issued with lower interest rates, the bond prices in the market go down as they are less attractive. They can trade lower than the face value of the bond. In the long run, if interest rates keep climbing up, bond prices would keep going down. In case you want to sell them before maturity in open market thru stock exchanges, you may lose money.
4) Reinvestment risk
Tax free bonds which are issued for long term, but where interest is paid at maturity, there would not be any issue. However, if interest is paid every year, you may not be able to get similar interest on such reinvestment amount. E.g. Last year, NHB has offered 9% tax free bonds where interest is paid every year. If one has invested Rs 1 Lakh, interest would be paid Rs 9,000 per annum. However, tax free bonds issued later to carry only 8.75% interest. Means if you want to invest any amounts later on based on returns received through such returns, you may end up investing in low return investment. Hence, you should always invest in long term high yield bonds where interest is re-invested at the same rate of interest and paid at maturity.
5) Inflation Risk
Generally bond coupon rate (interest rate) is priced higher than the inflation rate. The difference is real return (interest rate minus inflation rate). However, when inflation increases in the long run, you may not have the choice to take action to invest in bonds that yield the highest returns. E.g. Tax free bonds offered a few years back had a coupon rate of 7% per annum. Inflation during that time was around 4% to 5%. Means real return was 2% to 3%. However, when inflation crossed 7% in one year, the real return was negative. This inflation risk is there for long term bonds.
6) Liquidity risk
Generally, tax free bonds or NCD bonds are traded in the stock market and investors can sell them before maturity. However, when you want to sell, you may not have investors in the market to buy them. In such case you would not be able to encash them. This is termed as liquidity risk. You should invest money which may not need for some time.
Should you NOT invest in Corporate Bonds?
Identifying risks involved in investing in corporate bonds does not mean that we should not invest in them. These would help you to assess how well you are prepared to invest in such bonds.
- If you are investing in tax free bonds of Government enterprises, you can lock your money for long term at high interest rates like what we have seen in the National Housing Bank (NHB) tax free bonds which offered 10, 15 and 20 year bonds @ 9% interest. The credit risk would be low for such bonds.
- However, when investing in NCD bonds, issued by a private corporates invest for a short term to reduce credit risk, interest rate risk and liquidity risk.
- You should invest your money, which you do not need till maturity unless it is an emergency. This way you can come out of liquidity risk.
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Risks of investing in Corporate Bonds