Elaborate on the various risks involved in bond investment and recommend the techniques to reduce these risks.

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justaguide eNotes educator| Certified Educator

Bonds are fixed-income instruments where a rate of interest that the bond holder would receive is specified when the bond is issued and the period after which the bond can be redeemed is also mentioned. Bonds are issued by companies and by governments.

The primary risk involved when investments are made in bonds is that of the issuer defaulting. This can be quite high in the case of bonds issued by companies and it is compensated to an extent by variations in rate of interest. For the benefit of investors, there are several rating agencies which study the financial conditions of the issuer and give a grade to the bonds issued. If an issuer receives a low grade it has to provide a higher rate of interest and vice versa. Government bonds too carry the risk of default especially if they are issued by nations that do not have stable economic conditions. Depending on the risk the investor is willing to take, bonds of higher or lower grades can be bought.

Another risk with bond investment is that of the prevailing interest rate changing after the bond has been bought. If the interest rates rise, the investor is left with an asset that yields a lower return than what could be earned if the same funds were invested in an interest bearing instrument now. This risk can only be reduced by a proper analysis of the economic conditions and trying to predict how interest rates would vary in the future. Also, the investor should diversify the total investments that are being made and not use all of it to buy just bonds.