Majority of the Indian household savings are channeled towards fixed income instruments. These instruments are considered to be virtually risk free with high safety quotient. However, this is a myth. Let us understand why these investments are not completely risk free and how prospective investors should go about choosing them.
Predominantly, there are two types of risks associated with the fixed income instruments. The interest rate risk and the default risk. Now, let us understand these risks in greater detail. We know that interest rates and bond prices are inversely related. As interest rates increase, bond prices decrease and vice-versa.
Now, let us assume that interest rates are bound to decrease. In this case, the investor would benefit as bond prices would increase. But he would lose out on higher future interest income as interest rates now, have been lowered. Thus, his future re-investment income has been reduced. If the reinvestment loss exactly offsets capital gain effect from declining interest rates, the impact on bond return would have been neutral. But more often than not one factor dominates the other which affects the returns of a bond investor. This is called interest rate risk. And this affects all fixed income instruments.
Even default risk is an important factor to be considered while investing in fixed income instruments. The default risk is a risk of non-payment of principal and interest by the bond issuing company. Rating agencies typically analyze the financial health of bond issuers and assign a rating to them. This helps investors in gauging the default risk associated with the company's debt. Lower the rating, higher the default risk and higher the interest rate. A higher interest rate is offered to compensate for the risk associated with the company's debt. Thus, it should be noted that companies offering higher interest rate on their debt are not necessarily best investment avenues.
Reinvestment risk, a component of interest risk, also affects fixed income returns. Say for instance, you have invested in a 5 year fixed rate bond at 9% pa (per annum). Suddenly, the interest rate in the economy increase and a new issue hits the market with 11%. In such cases, investors who invested at 9% stand to lose out. Here, floating rate instruments offer a better hedge as their interest rates are periodically aligned to the market interest rates.
Lastly, it should be noted that interest rates which influence bond prices are governed by inflationary trends. Lower the expected inflation, lower the interest rate environment and higher the bond prices. Thus, inflation influences bond prices indirectly. As seen here, fixed income instruments are subject to a host of risk factors and investors should take them into consideration while making their investment decisions.