Plan to invest directly in bonds? Beware these risks or you could lose it all.

The recent reduction in the minimum ticket size for corporate bond investments from ₹1 lakh to ₹10,000 is a significant step towards this. While it opens up new opportunities for retail investors, it’s important to be aware of the risks before diving into bond investments, and remain vigilant once you do.

Retail investors often assume that bonds are safer than equities. While this is generally true, bonds come with their own set of risks.

Default risk

Kirtan A Shah, managing director at Credence Family Office, said, losses in fixed income instruments are permanent, unlike in equity, where market fluctuations offer a chance to recover. “Debt is not like equity. if your call goes wrong, you could lose your principal,” he said.

“When someone is paying you higher interest, there is a higher risk that you do not understand.”

The risk of losing capital is amplified when investors are lured by higher interest rates. Shah warned, “When someone is paying you higher interest, there is a higher risk that you do not understand.” His advice is that unless investors have the ability to assess why a bond is offering a higher coupon, they should avoid such investments.

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For retail investors, the first step to investing in bonds is understanding credit ratings. Lower-rated bonds generally carry higher risks. Shah suggested taking advantage of the wealth of information available online to evaluate the creditworthiness of a bond issuer. It’s also crucial to assess the sector in which the bond issuer operates and scrutinise the company’s financials.

Shah also pointed to an often-overlooked factor: what the bond issuer intends to use the money for. “You don’t want to be investing in a company that is burning cash to generate revenue or one that operates on high gross margins but spends a large amount to acquire customers,” he explained. Companies with unsustainable business models may struggle to turn a profit, posing significant risks to bondholders.

Interest rate risk

Harshad Chetanwala, a Sebi-registered investment advisor, highlighted several critical factors that investors should consider before making any decisions.

One of these is interest rate risk, which is higher for private bonds, but applies to all types of bonds, including those from the government. He explained, “When interest rates rise, the prices of existing bonds will decrease, affecting the investors’ returns.” This underscores the importance of understanding interest rate cycles, as these fluctuations can have a significant impact on bond investments.

“Debt mutual funds can help mitigate interest rate risks by allowing investors to diversify their investments across tenures.”

For investors with limited knowledge of bond markets, debt mutual funds – such as liquid funds, short term funds, mid duration and overnight funds – are a good alternative. “Debt mutual funds can help mitigate interest rate risks by allowing investors to diversify their investments across tenures,” said Chetanwala.

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The knowledge gap among retail investors regarding bonds is also a major concern. As Shah noted, “There is a huge knowledge gap when it comes to bonds, and retail investors are often fully unaware of the risks involved.”

The most severe consequence of bond investing, however, is default risk. A default can lead to a complete loss of capital, so it’s essential for investors to keep a close eye on their bond portfolios.

Debt funds vs bonds

One of the main attractions of bonds, said Devang Shah, fixed income head at Axis AMC, is the potential for higher post-tax yields compared to debt funds. However, investors should be aware of the charges that bond platforms levy, and other hidden charges.

Bonds, unlike debt funds, only incur taxes when they are redeemed, allowing investors to benefit from compounding returns without the drag of ongoing taxation. Moreover, bonds do not have an expense ratio, meaning the entire interest earned goes to the investor. Also, bonds allow investors to lock in interest rates for the entire tenure of the investment, offering a degree of certainty that debt funds, which are subject to market interest rate fluctuations, cannot provide.

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According to Shah, target maturity funds are a viable option for investors seeking some degree of certainty. These offer higher levels of disclosure and allow investors to lock in interest rates for the tenure of the fund, which reduces the impact of market fluctuations.

Investors must also remember that while the reduced ticket size lowers the financial threshold for participation, it does make them less risky. Shah said, “While the ticket size has come down, the underlying risk of the bonds remains the same.” Retail investors must be aware that bonds can have complex structures, including features like put and call options, which can significantly affect returns, like pre-payment charges for fixed deposits. Without a deep understanding of these features, investors may find themselves exposed to risks they are ill-equipped to manage.

Given these risks, Shah said debt funds may still be the better option for most retail investors. Debt funds offer greater transparency, with regular disclosures on credit quality, rating changes, the potential risk class (PRC) Matrix, riskometer, and liquidity. They also provide better diversification, spreading risk across a portfolio of bonds rather than relying on a single issuer.

Debt funds also offer liquidity that individual bonds cannot match, allowing investors to enter and exit their investments with relative ease.

Final thoughts

All of this goes to show that retail investors should not treat bond investments lightly. The allure of high-interest bonds can be deceptive, and without proper due diligence—particularly around credit ratings, sector performance, financials, and the use of funds—investors may face permanent losses.

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If you’re considering investing in bonds, it’s crucial to weigh the potential benefits against the risks and complexities involved. While the lower ticket size makes bonds more accessible, it does not necessarily make them safer or easier to understand. Thorough research and, where possible, professional advice are essential to navigating the bond market successfully. As the RBI and Sebi continue their efforts to expand retail participation, investors must remain cautious and informed to fully reap the benefits of this evolving investment landscape.