Know which risk is good and when

Last Updated: Wed, Jan 23, 2013 07:23 hrs

Investors who have invested in tax-free government bonds and want to sell may find it difficult to do so, as the secondary market for such bonds is almost nil. So, while these bonds have no credit risk as they are all top rated companies, they suffer from liquidity risk. Hence, it makes sense for investors to hold onto these instruments till maturity, since the post-tax returns are very competitive.

When it comes to investing not all risk is bad. The trick is in knowing which kind of risk one should take on and at what time. Knowing the kind of risk can also help you decide which product to invest in and for how long you should stay invested, says Feroze Azeez, director and head, investment products, Anand Rathi Private Wealth Management.

"The concept of risk plays a more important role when you invest directly in equities or debt. When you choose the mutual fund route, to a large extent the risk is reduced since there is a fund manager who decides which stocks or bonds to invest in," he says. High net worth individual investors who have invested in these tax-free bonds in the primary market may find some takers in the secondary market since there could be investors who feel it is better to lock into the high coupon rates now. But it could be particularly tough for retail investors (who have invested up to Rs 10 lakh), to sell these bonds since they have got 50 basis points higher coupon rate in the primary market, which will not be available for those buying the bond in the secondary market. Hence, a retail investor is not likely to find any buyers.

Another kind of risk in case of debt instruments is the interest rate risk. Interest rate risk is negative when interest rates are headed up and it is positive when these are headed down. Since, interest rates are headed downwards, now is a good time to take on interest rate risk, says Azeez.

A good measure of interest rate risk is the modified duration' of the debt instrument. Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates.

While investing in debt funds, in a falling interest rate scenario one should go for funds with higher modified duration, and conversely, in a rising interest rate scenario one should go for funds with lower modified duration. This data is available in the mutual fund factsheet.

Credit risk can be mitigated by investing in highly rated instruments or choosing mutual funds where the top 10 holdings are highly rated instruments. This data too, is available in the factsheet. In a bad macro economic scenario, investors should only look at AAA' rated securities.

If you invest in a bond with lower rating, but one that is offering higher interest rate, then you are exposing yourself to credit risk. If so, then you must ensure that liquidity risk is nil. So, choose bonds which have high liquidity, i.e., are traded actively. "Most corporate bonds fall into this category. They offer higher returns than government bonds, but are usually rated a notch below. If you invest in such bonds then it should not be for long term," says the head of research of a brokerage firm.

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