Reinvestment risk refers to the inability of the investor to reinvest the money received at maturity in another instrument offering a similarly high rate. This risk arises if interest rates within the economy have come down since the last investment. This is a risk that investors could face if they invest currently for the medium term.
NCDs are also subject to interest-rate risk — the risk of prices falling due to increase in interest rates. Currently, we are approaching the end of the rate hike cycle, so investors may not be exposed to interest-rate risk if they have a medium-term horizon. Rather, they may see bond prices appreciate over the next couple of years if rates fall.
Bank and corporate FDs allow premature withdrawal after paying a penalty. To exit an NCD, investors need to sell them on the stock exchanges where they are listed. As liquidity tends to be low, finding a buyer at fair value within a short period may prove difficult.
One step you can take to reduce credit risk is to build a diversified portfolio of issuers belonging to a cross section of industries. Don’t allocate more than 10 per cent of your capital to one issuer. Besides credit rating, study the company’s financial statements and avoid over-leveraged players.
To circumvent reinvestment risk, ladder your investments. To deal with liquidity risk, match your investment horizon with the NCD's tenure.
Strike a balance between risk and reward
- A 5-10-year fixed deposit from State Bank of India is currently offering 6.25 per cent
- A five-year NCD (rated AA or AA-) is currently offering 8.5-10.3 per cent
- Higher returns are usually accompanied by higher risk
- Most NCDs launched recently have a credit rating of AA or AA-
- It is safer to not invest in a paper below AA rating
- Invest in lower-rated papers only if you have done your research and are confident the company won’t default
- Even in that case, limit your exposure to lower-rated papers
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