Planning to add bonds to your portfolio? Manage these risks

As things got more uncertain for financial markets around the world these past weeks, “boring” bonds are on the radar again. Investors may be wondering if they should add bonds to their portfolios.

Let’s assume your current wealth portfolio has about 30% invested in a mix of debt funds, FDs, debentures etc. But given the current scenario, you want to add an extra buffer perhaps. For most investors with an existing portfolio of fixed income, adding some good quality bonds to it seems like a good idea.

Although, if you ask us, a better idea would be to either take the help of an advisor or go for reliable bond and debt funds. In the following paragraphs, we will explain why.

Bonds do give you the opportunity to own an asset that earns you regular income with the flexibility of moving in and out at your convenience. However, despite the perceived safety in earnings from bonds and debentures, they come with their own set of risks.

This is something you as an investor pondering over adding bonds to the fixed income part of your portfolio should be aware of.

The regular income from interest payouts is known in advance, but there is always the risk of default unless the bond is backed by the government. Transacting in listed bonds also has two unique risks. Here’s what you should know before you start hunting for some bonds you can invest in:

Risk number one – Interest rate risk

This is the biggest risk in bond investing through the secondary market and affects even the most secure government-issued bonds. So even if you did your research and invested in the best AAA-rated bond, you don’t escape this risk.

Once listed, bond prices are derived on a daily basis as the market price. Market prices of bonds move opposite to the change in interest rate.

The interest rate for the bond you buy doesn’t change, rather what changes over your holding period is the market interest rates and the expectations.

In a rising rate cycle, as is the likely scenario in 2022, the price of the bond you hold can fall with the expectation of a rate hike.

This happens because, in case of a hike in economy wide interest rates, newer bonds of the same tenure and quality will be offering a higher coupon and the older bonds fall out of favour.

The reverse happens when there is a falling rate cycle; older higher coupon bonds remain much in demand and hence, their price in the secondary market goes up.

• The point to note for you when making the decision: The risk is not so relevant at the time of buying, however, if while selling you catch the wrong end of the interest rate cycle, you could end up selling at a loss.

Risk number two – Liquidity risk

The other significant risk in secondary markets is, not being able to exit when you want. This can happen if there is no demand for the bonds or in other words if there is no buyer.

The Indian bond market is notorious for its lack of liquidity and even depth.

What this means is that for the existing listed bonds, there are not enough transactions that happen on a daily basis, volume is low and also that there is a lack of choice when it comes to buying bonds within a category.

The risk does not manifest much when you want to buy, because you will ultimately go for whatever is available in the market on the day you go to invest. However, when it comes to selling, lack of liquidity can impact the price you receive per bond or even delay the actual date of sale.

• The point to note for you when making the decision: When you buy and sell in the equity market, most of the large and mid-cap stocks have enough liquidity to match transactions on a daily basis. This is not the case for the bonds issued (and listed) by the same large and mid-cap companies.

Takeaway for you before you decide

Both these risks do appear to be a deterrent for you to invest in bonds through the secondary market.

At the same time, if you want to take advantage of bond yields and are keen to look at the listed bonds for their flexibility, your best alternative is to take the help of an advisor.

Good financial advisors have an information edge over investors in terms of market data and can effectively guide you to the bonds with high liquidity, plus advise around the interest rate cycles.