Many people live in the misconception that the fixed income products like bonds etc. are risk free. People who are not much aware about the investment schemes and know how to analyze them or find the hidden factors think them to be the best option for investment. But this is not the actual scenario. Though it is true that fixed income sources are safer than other investment schemes. But these are sometimes misguiding as risk free investment. So, know the following risks associated with your investment before managing your portfolio.
Interest Rate Risk
The products which have fixed interest rate earnings will not be good for your portfolio if the interest rate has otherwise increased on later date. For eg: if you bought a ten year bond at the fixed rate of 7% and after two years interest rate becomes 8%. Then you will be getting lower gain with higher risk on investment. Though the vice versa case will be beneficial for you. But it is better if you buy this product with proper hedging purpose. Or you should buy the product will fluctuating rate. So, that your earnings also go up and down with the risk movement.
Inflation adversely effects the investment in bonds. This is because the interest earned in simple interest at the fixed rate. Whereas inflation inflates a compounding value with fluctuating rate. So, the investment made today with the planning to get the good returns later might not be that effective due to inflation. For eg: the return of 10% seems to be good if the inflation is at 8%. But the actual calculation shows that the planning is not fruitful in few years.
If the prepayment of bonds is done, it results in two types of risks i.e. contraction risk and extension risk. Contraction risk is due to declining interest rates. Whereas the extension risk is due to increasing risk rates where the investor makes the prepayment to buy other bonds with higher returns. But the prepayment results in lesser yields as well.
This is generally neglected in case of bonds. But if we analyze it properly we see that the credit ratings of the bonds issues effects the rate of interest. The chances of default are very less in this case. But if the quality of books are deteriorating, the credit rating companies will downgrade them. So, the interest rate should be increased. But you will be again earning lower returns at higher risks.
The amount or interest earned from the investment is reinvested in some cases. But the rate of return on the reinvested value is not the same.
These bonds are a point of attraction for the investors because they have tax benefits if the terms and conditions are fulfilled. But with the changes in the planning commission forecasting, there might be decrease in the tax rates. So, these bonds will not be much beneficial as they were initially. This risk does not effect much in your portfolio management.
So, it is advisable to know more about the products from your financial planner rather than investing with pre mind set. Investment in stock market is not good without proper knowledge. But there are good options available in the market like mutual funds or floating rate products etc to have good returns.