Question

Why would you want to invest in a bond over a stock? What are some of the risks associated with investing in bonds?

Answer 1

Answer:-

The investment in bonds is advantageous than investing in stocks because the bonds pay fixed coupon payments and the principal at maturity, whereas the stocks are highly volatile and is not liable to pay dividends and can decrease the value of stocks which can cause huge losses to the investor.  

The risks associated with investing in bonds are:-

1) Credit risk:- This risk is that the company which issues bonds may not be able to pay the interest payments and the final face value on maturity. This may lead to default by the issuer company. In general the government issued bonds are much safer than corporate bonds that are issued by private companies.

2) Inflation risk:- This risk mostly comes into picture when there is rise in inflation. If the interest rate paid by the bonds is less than the inflation rate the return earned from investing in bonds will be negative.

3) Interest rate risk:- The bond prices movement is inversely related to interest rates. When the interest rates rises the bond prices decreases and vice versa. If the interest rate increases the bond prices will decrease and if we are selling the bond before maturity we will incur a loss.

4) Market risk:- The risk occurs when there is fall in the bond markets which decreases the prices of all the bonds irrespective of quality, whether its an investment grade bond or a junk bond.

5) Reinvestment risk:- In the scenario of falling rates the investors have to invest the coupon payments and principal at lower rates thus decreasing the returns.

6) Liquidity risk:- The liquidity risk for the bonds involves when the market is not liquid and the investor cannot find a buyer and may have to sell the bond at lower prices.