By Sunil Parameswaran
Ask a layman why he or she invests in a government bond, and they’ll tell you because it’s risk-free. Government securities are known as Gilts. Indeed, in ancient England, government issued debt securities were accompanied by a gold leaf border. So, there is a belief that gilts are risk free securities, which are as good as gold.
What people don’t realize is that the risk of default is just one of the many risks associated with investing in debt securities. So while bonds issued by a country’s central or federal government may be free from default risk, other risks exist. One of the main risks is interest rate risk. Interest rate risk, unlike other risks, affects a bondholder in two ways. First, all bonds except zero coupon bonds pay periodic coupons, which must be reinvested to earn a compound rate of return.
There is therefore a reinvestment risk, ie the risk that interest rates will be low, when the coupon is paid. The second facet of interest rate risk is market risk or price risk. This is the risk that interest rates will be high when the bond is sold in the secondary market, and the higher the current yield, the lower the price received by the holder. The two risks work in opposite directions.
Reinvestment risk hurts the holder if rates fall, while price risk impacts if rates rise. It should be remembered that if the bond is held to maturity, there is no price risk, as the face value will be paid. So, to avoid both default risk and interest rate risk, an investor should buy a zero coupon government security and hold it until maturity. Keep in mind that while zero coupon bonds have no reinvestment risk, they still have price risk if they are traded before maturity.
The next risk to consider is the risk of inflation. Most securities, including government securities, pay the nominal cash flows promised. However, there is no guarantee what can be acquired with the payments received. If the inflation rate is high, the purchasing power of the cash flows received from the bond will decrease.
To overcome this risk, governments issue bonds indexed to inflation. There are two possibilities. Principal or coupons may be indexed to inflation. The former is known as P-Linker, while the latter is known as C-Linker. In the case of P-Linkers, the principal is periodically adjusted based on a price index such as the Consumer Price Index (CPI). A fixed coupon rate is then applied to the adjusted principal. In most cases, in the unlikely event of deflation, if the maturity-adjusted capital is less than the original capital, the government will repay the original capital.
In the case of C-Linkers, the principal will remain fixed at the initial face value. In each period, the inflation rate will be added to a fixed or real rate. The sum of the two rates is then applied to the principal. If, due to deflation, the sum of the two rates is negative, the practice is to set the coupon to zero.
Thus, risk has many dimensions, even with a supposedly risk-free asset such as a government bond.
The author is CEO of Tarheel Consultancy Services