What are the risks of Investing in Debt Securities- Are you really secured?
With the recent fall in the equity market, investors at various platforms asking this question whether they should exit the market and rather go for other secured Debt instruments. In this connection, I felt the necessity to tell the investors the real truth behind the inherent risks of investing in debt securities. So, today I have decided to write a blog post on What are the risks of Investing in Debt Securities – Are you really secured? In a nutshell, what types of risks an investor of debt instrument may have to face.
Whenever the stock market indices tend to stay at the red for a bit longer time, the investors (rather I would say Short-term investors) have always shown their paradoxical characters and tend to exit the equity market even with incurring losses on their investments. This used to be the usual practice of the investors till now. Now, just let’s see the recent monthly SIP data published by AMFI India below.
*Data source AMFI India
The above chart shows the monthly SIP contribution for the F.Y 2018-19 till September 2018. Total investment till September 2018 is Rs.44,487 Crores.
But the recent investment in SIP data as published by AMFI INDIA will surely break the myth. Also, it will be quite interesting to see that how the investors have performed in October 2018 in terms of investment in equity-related products. For this information, we have to wait for the next monthly data to be released by AMFI INDIA. I hope the growth story will likely to be continued and the mid to long-term investors will be in a position to take advantage of the rupee cost averaging factor along with the Compounding factor which is called the 8th wonder of the world.
# What investments are termed as Debt products?
All those investments which are made to earn a predefined return over a fixed tenure are called debt products such as Fixed deposits, savings schemes, bonds and partly debt mutual fund products
# I am an investor of Debt instruments/products, what type of risks of investing in debt securities I have to face?
To answer this question first we must know the types of risks of investing in debt securities. See the picture below before starting off.
First, we must know that no investment in this economic world is risk-free so as debts instruments. Therefore, let’s know what risks an investor has to face while planning for investing in debt products.
# Risks of investing in Debt Securities:
#1. Inflation or purchasing power risk
Inflation or purchasing power risk can be termed as the risk of getting pre-committed fixed returns on investments in debt products. Let’s understand with an example. For e.g., if a Fixed Interest bearing Fixed deposit or Bond promises a return of 7% for 3 years period, it will be retained as a very good investment until the inflation rate is below 7%. But, if the inflation rate is higher than 7%, the real return from this investment will turn negative. Therefore, investments in debt securities become very vulnerable in a high inflationary condition, unlike equity investments which can match a return more than inflation if remain invested for a longer tenure.
#2. Default or credit risk
Default or credit risk refers to the risk that an investor may face if the issuer of any bond fails to make repayment of the principal or interest or both. However, in this connection, I must mention that the Bonds issued by the Govt. is completely free from default or credit risk. All other debts are exposed to this credit risk. You may go through an answer which I was asked in Quora regarding investment in high coupon FD.
Since the majority of the Indian investors are still very much risk-averse(though the number is decreasing day by day), more and more institutions are offering highly lucrative coupon rates in spite of the lower credit ratings. Usually, the risk of an instrument can be measured by the credit rating mark imposed on it by the credit rating agencies.
Therefore, I can say that the credit rating is an indicator of the risk factor associated with that instrument. Low rated(credit ratings) high coupon bonds offered by some companies are badly exposed to default or credit risk. Similarly, the unsecured debts such as corporate fixed deposits offered by some companies promise to pay higher coupon rate than secured bonds, since they don’t have any recourse on the assets of the issuer companies.
#3. Reinvestment risk
Investors of debt securities have primarily two options offered by the debt issuers such as a. periodic interest payouts or b. cumulating the interest payouts and reinvestment of the same. Sometimes, it may so happen that the investors take out the periodic interest though they don’t require this cash flow on regular basis. In that case, the investor loses out the opportunity for reinvestment of the same at a higher coupon or at the same coupon rate in case of a growing economy whereby the interest rate is falling periodically. In this situation, their investment is exposed to reinvestment risk.
Similarly, if the investors choose for reinvestment of the periodic interest, predominantly, they do so at the same coupon or interest rate. In that case, also their investment is very much likely to be exposed to reinvestment risk.
#4. Call or buyback risk
This is a kind of risk which an investor generally has to face if the bond issuers decide to call back the security before the maturity period. This situation occurs very frequently when in a growing economy the interest rate is falling drastically and the issuers are to pay a high coupon rate. They just tend to call back their securities before maturity period ends and issue new securities or bonds at the lower coupon rates. Since the investors frantically go for safer investments, as a result of this they are exposed to this risk and are left with no other option but to invest at lower rates.
#5. Liquidity risk
Most of the bond investors are likely to hold the bonds till maturity as because of limited liquidity at the secondary market. Leading to this, they have to face severe liquidity risk as there is no one to buy the bonds. Technically there is an inverse relationship between the market and bond.
If the market rate goes down the bond price goes up, subsequently, the investors are not in a position to sell their bonds as no one is interested to buy this bond at a high price. Similarly, if the market rate goes up, the bondholders can not switch immediately to high coupon rate bonds due to their limited liquidity and have to gallop the lower coupon. Also, if the quality of the functioning of the company reduces in terms of low credit rating during the tenor of the bond, the investors are exposed to some sort of credit risks as well.
Final word on What are the risks of Investing in Debt Securities – Are you really secured?
In the end, I must mention that I am not against the debt securities at all. It has been my endeavour to bring forth the inherent nature of any investment products. Investors who always tend to go for debt securities for safer investments must think after going through this blog post whether their investments in these debt securities are risk-free indeed. Are they really secured?
I am a strong believer of the equity and equity-related products and the way the mutual fund is growing as you can see from the monthly SIP data published by the AMFI India, I am quite hopeful that in a few years the dependency on the secured investments of the Indian investors would go down drastically and would evolve as a new era for the equity market like other developed nation currently is going through. If you like my post kindly share this with others so that they can learn from this.
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