What people do not realise is that default risk is only one of many risks associated with investments in debt securities.
By Sunil Parameswaran
Ask a layman as to why he or she invests in a government bond, and they will say because it is risk-free. Government securities are known as Gilts. This is because in ancient England, the debt securities issued by the government came with a border made of gold foil. Thus, there is a belief that gilts are risk-free securities, which are as good as gold.
What people do not realise is that default risk is only one of many risks associated with investments in debt securities. Thus, while bonds issued by the central or federal government of a country may be free of default risk, the other risks exist. One of the key risks is interest rate risk. Interest rate risk, unlike other risks, impacts a bondholder in two ways. First, all bonds, with the exception of zero-coupon bonds, pay periodic coupons, which need to be reinvested to earn a compounded rate of return.
Thus, there is reinvestment risk, which is the risk that interest rates may be low, at the time the coupon is paid out. The second facet of interest rate risk is market risk or price risk. This is the risk that interest rates may be high when the bond is sold in the secondary market, and the higher the prevailing yield, the lower will be the price received by the holder. The two risks work in opposite directions.
Reinvestment risk hurts the holder if rates decline, while price risk impacts him if rates rise. It must be remembered that if the bond is held till maturity, then there is no price risk, for the face value will be paid out. Thus, to avoid both default risk and interest rate risk, an investor must buy a zero-coupon government security, and hold it till maturity. Remember that, while zero coupon bonds have no reinvestment risk, they nevertheless have price risk, if traded before maturity.
The next risk to be considered is inflation risk. Most securities, including government securities, pay promised nominal cash flows. However, there is no assurance as to what can be acquired with the payouts received. If the rate of inflation is high, the purchasing power of the cash flows received from the bond will decline.
To overcome this risk, governments issue inflation indexed bonds. There are two possibilities. Either the principal or the coupons may be indexed to inflation. The former is known as a P-Linker, while the latter is known as a C-Linker. In the case of P-Linkers, the principal is adjusted periodically based on a price index such as the consumer price index (CPI). A fixed coupon rate is then applied to the adjusted principal. In most cases, in the unlikely event of deflation, if the adjusted principal at maturity is lower than the original principal, the government will pay out the original principal.
In the case of C-Linkers, the principal will remain fixed at the initial face value. Every period the rate of inflation will be added to a fixed or real rate. The sum of the two rates is then applied to the principal. If, due to deflation, the sum of the two rates is negative, the practice is to set the coupon to zero.
Thus, there are a lot of dimensions to risk, even with a supposedly risk-less asset like a government bond.
The writer is CEO, Tarheel Consultancy Services