Debt vs Equity - 5 Major Risks in Debt

Debt instruments are great investment avenues to generate regular guaranteed cash flows as well as to preserve the wealth for long period of time. However, the guarantee does come with multiple risks. Investors need to understand those risks before investing in any kind of debt instruments.

Credit/Default Risk

Investing in debt is nothing but lending money to a borrowing entity who must repay with a predefined fixed/variable rate of interest. In this mechanism, the credit worthiness of the borrowing entity becomes crucial. While the GSec and PSUs come with a sovereign guarantee, there is no such guarantee in case of corporate bonds. It is completely dependent on the company’s ability to repay the debt.

In case of default, investors not only lose the interest income, but the entire capital as well. Always remember that the focus on debt should be RETURN OF CAPITAL and not RETURN ON CAPITAL.

The recent credit defaults by Yes Bank, IL&FS, DHFL, Reliance ADAG group have highlighted the prevalence of credit risk across the debt market. When a company suffers to serve its debt obligations and eventually defaults, there is permanent loss of capital.

Even in a debt MF, if the debt MF schemes have exposure to these riskier papers & in case of defaults, NAV will fall to the extent of its weightage on the MF scheme’s portfolio. Despite debt MF schemes having diversified portfolios, it is difficult to escape from credit risk if the corporates defaults on its debt papers. Balarpur paper mills & Amtek auto are example of “credit risk” events faced by various MF schemes.

Rating Downgrade

A borrowing company’s operational ability, debt obligations and credit worthiness is frequently assessed and evaluated by credit rating agencies famously Standard & Poor's and Moody’s. The ratings range from ‘AAA rating for strong credit quality’ to ‘D for defaults’.

Even if the entities come with the same AAA rating, some companies’ papers trade with a higher valuation (less yield) as compared to other AAA papers (high yield). For example, even though HDFC Ltd. & IL&FS had AAA rating, HDFC’s paper was trading at higher valuation with 6% - 6.5% yield whereas IL&FS was trading at a lower valuation with 8% yield and we know how the crisis arose in IL&FS in 2018 and the rating was downgraded drastically.

Overall, the rating is a key input to decide, but not the sole input. You need to be very careful while selecting the corporate bonds, do remember that higher return always comes with higher risk. If we refer the above example, markets did not recognise the AAA rating of ILFS as equal to HDFC Ltd and eventually, ILFS traded at higher yield (lower valuation). Hence, despite the good ratings i.e AAA etc, the risk needs to be assessed based on yields of corporate relative to sector/industry it operates in.

Interest Rate Risk and Bond Prices

This is another aspect which an investor must understand. There is an inverse relationship between the interest rate and the bond price. When the interest rate increases, the price of the existing bond falls and vice-versa.

For example, take a case where an investor holds a bond with yield of 5%, and the prevailing market interest rate rises to 6% (Repo Rate to a large extent). In this case, the investor would want to SELL the existing 5% yield bond and reinvest with 6% yield papers. Demand for the existing bond would come down bringing the price of the bond down. When the interest rate in the market rises, the market price of the bond comes down & vice-e-versa. If he liquidates it, the value will be more likely lower than the principal investment.

Reinvestment Risk

Another risk that is associated with debt investment is the risk of Reinvestment. In simple words, when you receive the guaranteed return from the investment, you may not get the reinvestment opportunity with the same return profile. You may end up reinvesting at a lower rate of return.

For example, suppose you invested in a bond 5 year back which yields 8%, now when it matures, there is no opportunity to reinvest the maturity proceeds at 8% yield with same risk reward ratio. Hence, if you are clear with “locking funds for the long term to get guaranteed/regular fixed income”, do it when the interest rate cycle nears its peak.

Liquidity Risk

This liquidity risk was earlier less talked about. However, the liquidity issues faced by Franklin MF 2 years back highlighted this risk significantly.

While there is negligible risk of liquidity in GSec, corporate bonds are highly exposed to liquidity risk. It means, you may not be able to sell your bonds in the secondary market as and when you desire if there is less or no demand for the paper that you hold.

This demand can be attributed to many factors like rating downgrade (e.g. IL&FS papers after the crisis), rising interest rate, tenor, ticket size etc. However, please note that there is no risk of liquidity if you hold the papers till maturity.