What are the disadvantages of a bond?

The recent rate hike by the Reserve Bank of India has led to the increased popularity of the bond market. Zero-coupon, convertible, and inflation-linked bonds are among the various bonds traded in the bond market. In India, the central and state governments, municipal and local bodies, corporates, and public sector undertakings issue bonds that trade in the Primary and secondary market.

However, like every asset class, there are various pros and cons of bonds. This article highlights the primary disadvantages of bonds.

Disadvantages of Bonds

In the bond markets, the type of security, period of holding, and nature of the issuer impact the overall performance of the security. For instance, short-term and medium-term bonds tend to be less volatile than long-term bonds. Similarly, bonds issued by governments, municipal corporations, and local authorities tend to be less risky than corporate bonds.

Some of the disadvantages of bonds include interest rate fluctuations, market volatility, lower returns, and change in the issuer's financial stability.

The price of bonds is inversely proportional to the interest rate. If bond prices increase, interest rates decrease and vice-versa. Hence, the total value of your bond portfolio may suffer from rising interest rates.

Furthermore, a change in bond prices directly impacts the mutual funds and institutional investors with exposure to bonds. This affects professional investors such as banks, pension funds, and insurance companies.

  • Interest Rate Fluctuation

    The price of bonds is inversely proportional to the interest rate. If bond prices increase, interest rates decrease and vice-versa. Hence, the total value of your bond portfolio may suffer from rising interest rates.

    Furthermore, a change in bond prices directly impacts the mutual fund and institutional investors with exposure to bonds. This affects professional investors such as banks, pension funds, and insurance companies.

  • Market Volatility

    Bond markets are highly interlinked. Market volatility and macroeconomic factors affect bond prices irrespective of the underlying fundamentals of the issuer. The ratings allocated by credit agencies also significantly influence bond prices. Rating agencies can either upgrade or downgrade an issuer based on its financial health.

    An unexpected downgrade can lead to a fall in bond prices. Such external factors do not impact the coupon or interest payment of the bond; instead, it affects the market prices of bonds.

  • Return on Investment

    Fixed-rate bonds pay a predetermined interest rate at regular intervals. The interest rate for floating rate bonds tends to fluctuate based on a benchmark rate. Examples of benchmark rates include Consumer Price Index or London Interbank Offer Rate.

    In the long run, the return on investments for bonds tends to be lower than for equities. In India, the average return from bonds is 7% per annum, whereas equity investments yield about 12%. Also, the tax implication for bonds is more than equity, so the overall return from bonds is significantly lower than equity.

  • Financial Stability

    The financial stability of the issuer has a direct impact on bondholders. Bondholders face a capital risk in case of bankruptcy or liquidation. In India,Bondholders have a right to the assets of a liquidated company in precedence to some other creditors. However, there is no guarantee for the amount of repayment. The restructuring may reduce the overall value of the bonds. Alternatively, issuers may face liquidity issues that may hamper the bondholders' interest or principal repayment schedule.

    Most importantly, the bond markets in India are not as developed as the equity markets. The bond market is underdeveloped due to the lack of a centralized exchange and market regulator and fewer market participants.

Risk Involved in Bonds

Each investment avenue is subject to risk, and the bond market is no exception. Some of the risks include:

  • Credit Risk

    Credit risk refers to the possibility of default by the issuer in case of cash-flow problems. As discussed above, various factors may impact the issuer's financial stability.

  • Event Risk

    Issuers may face unforeseeable circumstances that directly affect their financial health or liquidity. For example, change in laws and regulations adversely impact business.

  • Reinvestment Risk

    Callable bonds are subject to reinvestment risk. The issuer may choose to pay off callable bonds before their maturity date. Generally, issuers recall bonds in case of a fall in interest rates. Investors then have to reinvest the principal at lower rates.

Other risks associated with bonds also include prepayment risk, inflation risk, exchange rate volatility, sovereign risk, and exchange rate risk.

Disadvantages of purchasing bonds OTC

Over-the-counter (OTC) markets refer to securities trading beyond a formal exchange where dealers quote the purchase and sale price of securities. Additionally, the primary risk with the OTC market is the lack of reliable information and transparency. Consequently, market manipulation is easily achievable.

Bonds are traded very delicately on the OTC market. Hence, the bid-ask spread may be considerably higher, leading to lower liquidity in the market. The absence of exchange and clearinghouse increases the risk of trade defaults in the OTC markets.

Overall, purchasing bonds over the counter is subject to speculation and leads to market integrity issues.

Bottom Line

Despite the various disadvantages of bonds, they are relatively safe investments. A well-diversified portfolio must include some amount of debt. The quantum and allocation of debt depend on the investor's risk appetite.