What are the risks associated with debt instruments?

Let us understand what a debt instrument is all about. When I invest in a debt instrument I am promised by the borrower that I will get my principal back after certain period and periodically there will be an interest payment because I have given my money to somebody.

Now let us look at the risk. The first risk - what if I do not get the promised money as per the agreed schedule; either there is a delay or the money does not come back to me at all, popularly known as the credit risk or the default risk. One can assess this risk or evaluate this risk through a process called credit rating. There are agencies which assign credit rating to various debt instruments. A debt instrument carrying AAA rating is considered to be the safest, something carrying AA is less safe as compared to an AAA rated and something that carries BBB is even riskier compared to an AA rated instrument. So that is credit risk.

Let us look at the regular interest payment or the promise of interest payment. Assume that I have invested in a bond which promised to pay 9 percent per year. If in the market some other company comes out with an issue of bonds offering 10 percent and if both the bonds happen to be very similar then the attractiveness of the bonds where I have invested my money goes down, which means if the interest rates in the economy went up, all the existing bonds become less attractive and less attractive means the market price of these bonds start to come down. So if I have to sell the bonds in the market I will incur a loss.

Third risk in bonds is once again coming back to that 9 percent interest. Assume that I am invested in a bond which gives me 9 percent per year Year-after-Year and the bond is a 5 year bond. At the end of the first year when I received that 9 percent interest income at what rate do I reinvest? The rate would be a function of what are the other bonds or what is the market offering at that point in time, which means all the interest income that I receive periodically the reinvestment rate is uncertain. So that is reinvestment risk.