The degree of interest rate risk associated with a given bond depends on the size and timing of the cash flows, interest and principal, from that bond.
Bond, popularly known as a fixed-income instrument, allows government, companies, and other issuers to borrow money from investors. In portfolio management, fixed-income securities play a vital role. Adding fixed-income securities to portfolios including common shares is usually an effective way of obtaining diversification benefits. However, investing in bonds is not entirely risk-free.
Let us understand the type of risks and the mitigation strategies.
Bond is basically an acknowledgement of debt. Unlike equity shares, wherein one need to find out the intrinsic value, here the valuation is relatively easier. The cash flow in terms of interest and principal repayment are known in advance. However, bond investors face several types of risk. One is credit or default risk, which is the risk that the bond issuer will not repay the principal invested. Since very few debts issuers default on their obligations, it is less of a worry for most investors. The other major risk is interest rate risk.
Components of interest rate risk
This consists of reinvestment risk and market risk. Reinvestment risk is the risk that cash flows received from an existing investment, like interest or maturity amount could be reinvested at different interest rates than those paid on the existing security. When market interest rates rise, reinvestment risk works in the investor’s favour because the cash flows received can be reinvested in higher-yielding securities.
When interest rates fall, reinvestment risk works against the investor. Market risk is the risk from fluctuation in the market price owing to changes in market interest rates. Interest rates and bond prices move in opposite directions. When interest rates rise, prices of bonds fall, and vice versa. How to measure the intensity of interest rate sensitivity on bond price is an interesting question to answer.
The degree of interest rate risk associated with a given bond depends on the size and timing of the cash flows, interest and principal, from that bond. Bond duration is a way of measuring how much bond prices are likely to change as and when interest rates change. In other words, bond duration is a measurement of interest rate risk. Understanding bond duration can help investors to determine how bonds fit into a broader investment portfolio.
Generally, duration is measured in years. For instance, if a bond has a duration of five years and interest rates increase by 1%, then the bond’s price will decrease by approximately 5%. Contrary to the above, if a bond has a duration of five years and interest rates fall by 1%, the bond’s price will increase by approximately 5%. So, higher the duration of a bond, meaning the longer you need to wait for the payment of interest and return of principal, the more its price will drop when interest rates rise.
Bonds may not be as attractive as stocks, but they are a significant component of investment portfolios. Bonds are traded in huge volumes much higher than that of equities in value, but their full usefulness is often underappreciated and underestimated.
Bonds definitely help to diversify and reduce risk in your investment portfolio. Interest payments from bonds can act as a hedge against the relative volatility of stocks, real estate, or commodities. The interest payments also can provide you with a steady stream of income.
(The writer is a professor of finance & accounting, IIM Tiruchirappalli. Views are personal)