5 risks investor faces in risk-free fixed income investing

Nitin VyakaranamArthaYantraMany of us believe that there are a few ‘Risk-Free’ investments available in the market. It is a myth that investing into these risk-free instruments would yield us good returns without taking any risk. If we search the term ‘risk-free’ interest rate on internet, it shows us a definition which says “risk-rree interest rate is the theoretical rate of return of an investment with no risk of financial loss”.We believe that fixed income investments like PPF, FD, RD, and government bonds instruments provides us risk-free returns. This is because we profoundly trust banks and government which ensures their credibility and returns. To an extent these facts are right but there is an element of risk in these investments which should not be ignored by the investors. Here are some of the risks that an investor has with the risk-free investments: 1) Credit Risk Credit risk may arise when the investment issuer defaults in paying debts. Default can happen due to consistent losses by the organization which result in non-payments of interest, wages or in banking terms ‘insolvency’. If such risk happens then recovery of the principal amount invested would be difficult. However, this kind of risk is very less likely to happen in India where banks have strong fundamentals. 2) Market Risk This risk can happen in government bonds. Risk occurs due to demand and supply gap. Government bonds are traded in the market and their values would largely depend on investor sentiments. Only thing that is secured in the bonds are regular payment of interest. Principle amount invested in the bonds would be subjected to the market price which is driven by the buyer and sellers of the bonds.3) Inflation Risk Risk-free instruments have fixed rate of returns and have a long-term period of investing. During this tenure of investing the returns are always subjected to risk which is due to the inflation in the economy. Higher inflation rate would impact the real rate of returns in the investment (Real Rate = Returns – Inflation) which is anyways not very high under normal circumstances. For example : A fixed deposit having a returns of 9% per annum would have a real rate of return of just 1%, if the inflation is at 8% per annum. In case of inflationary market this real rate may go below zero which indicates negative growth of investments. 4) Liquidity Risk Fixed income securities may give pre-defined returns but due to long-term nature of the investment (PPF, Government Bonds) it becomes difficult for the investor to withdraw the investment before the maturity period. This causes liquidity risk to an investor, as withdrawal costs him to lose some of his principal amount. This mostly happens in government bonds, where the bonds are purchased for long-term and are not available for redemption before it matures.5) Interest Rate Risk Interest rate is an ideal indicator of the inflationary trends and economic growth in the country. This interest rate indirectly affects the fixed income investments as it changes as per the inflation rates. If there is an increase in inflation then interest rate would also increase which will reduce the net yield from these fixed income securities and vice versa.ConclusionFor investors with low risk appetite, it would be a logical choice to go for fixed returns investment options. However, care should be taken to keep the above risk factors in mind before choosing the investment option. Also, it would be prudent to keep in mind that there is nothing like “Risk-Free” when it comes to investments.