Find out the bond investment risks before you want to start in the following article.
A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors who are willing to lend them money within a certain period of time.
When you buy a bond, you lend it to the issuer. In return, the issuer promises to pay you a certain rate of interest over the term of the bond. Bond issuers are indebted to bondholders and are obligated to pay interest or repay principal on the maturity date.
Just like any investment, bond investing also has risks. The following are some of the risk factors you need to consider before making a decision to invest in Bonds.
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1. Liquidity Risk
One of the drawbacks of bond investing is liquidity risk. This is a bond investment risk when investors want to sell bonds and have trouble finding buyers. This forced him to sell at a significant discount. Investors may be able to find solutions to minimize this risk.
2. Inflation Risk
Inflation reduces the purchasing power of future coupons and bond principals. Because bonds tend not to offer unusually high returns, they are particularly vulnerable when inflation rises.
Inflation can lead to higher interest rates which have a negative impact on bond prices. Inflation Linked Bonds are structured to protect investors from inflation risk. Coupon flows and principal (or nominal) increases are in line with inflation rates. Therefore, investors are protected from the threat of inflation.
3. Reinvestment Risk
If you hold bonds to maturity or sell them before maturity, there is a bond investment risk that you may only be able to invest the proceeds at a lower rate of return.
When interest rates fall, this is an important risk to consider when buying short-term bonds. Reinvestment risk also applies to coupon payments you receive over the life of the bond and you may not be able to reinvest them at the same rate of return.
4. Interest Rate Risk
An increase in interest rates will result in a decrease in bond prices. This reflects the ability of investors to earn attractive rates of interest on their money elsewhere.
Lower bond prices mean higher yields or returns available for bonds. Conversely, a decrease in interest rates will result in higher bond prices and lower yields.
Before investing in bonds, you should assess the duration of the bonds (short, medium or long term) in relation to the interest rate outlook. This is to ensure that you are comfortable with the potential volatility of bond prices due to fluctuations in interest rates.
Those are some of the risks of bond investment that may be important for you to know. Please note that all investments have their own advantages and disadvantages. So, it’s a good idea to study first before deciding to invest in any field.