Bonds are often considered “safe” investment options. With decent returns, lower risk compared to equities, and regular payments, they have become a haven for traditional investors. Moreover, if debt mutual funds invest in bonds, why shouldn’t I invest in them directly and avoid the expense ratio? Many people follow this logic.
But is investing in bonds truly risk-free, especially corporate bonds? Perhaps not.
You might be surprised to learn that nearly 96% of bond market participation comes from institutional investors, leaving limited opportunities for retail investors. In other words, the bond market is largely a playground for institutional players. This underscores the need for knowledge and experience when navigating bonds.
Most investors who prefer direct bond investing do not fully understand the risks involved. So, let’s explore the risks. We will break down the common risks of direct bond investing that every direct bond investor must recognise.
What exactly is a bond?
A bond is a fixed-income instrument that gives an investor a fixed interest-rate payment at its maturity.
When a company or the government needs money, instead of taking a loan from the bank, they borrow from investors like you and me. In return, they promise to pay you back your money (the principal amount) on a fixed date (maturity), along with periodic interest payments, usually called coupons.
If you buy a 5-year bond worth ₹1,00,000 with a 7% annual coupon, you will receive ₹7,000 every year as interest, and at the end of 5 years, you will get your ₹1,00,000 back.
How do bonds work?
The key thing to remember is that bonds are tradable instruments. Their prices move up and down in the secondary market, just like stocks. This means if you need to exit early, you might not get your full ₹1 lakh back. Bond prices fluctuate based on prevailing interest rates and demand for that bond.
Every bond is rated. Depending on who issues the bond, the risk and return profile changes drastically.
How are bonds rated, and why do ratings matter
The strength of a bond relies on one crucial factor: the issuer’s ability to repay. This repayment ability determines whether a bond is considered “good” or “bad” from an investment point of view. That means, every bond is assigned a credit rating, reflecting its involved risk level.
Investors don’t usually analyze bonds before investing. To bridge this gap for them, credit rating agencies evaluate the financial strength of issuers and assign ratings that reflect their repayment ability. Their role is to evaluate how likely they are to meet their obligations, paying interest regularly and returning the principal at maturity.
In India, the most prominent rating agencies are:
- CRISIL – Credit Rating Information Services of India Limited
- ICRA – Investment Information and Credit Rating Agency of India Limited
- CARE – Credit Analysis and Research Limited
Each of these agencies has the same purpose: to give investors a clear picture of the bond’s creditworthiness. Ratings typically range from the safest (like AAA, which indicates a very low risk of default) down to D (which signals a high likelihood of default). These ratings are symbolically represented as CRISIL AAA, ICRA AAA, CARE AAA.
Bond credit ratings by CRISIL, ICRA, CARE
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What can we learn from the table?
Bonds at the highest safety level carry the least risk. The chances of the company, with the ratings in “A” range, missing payments are low. Similarly, lower-rated bonds promise higher returns, but they expose you to even bigger risks, including the risk of losing a part of your capital or the entire amount.
A precautionary note for you: The twist most investors overlook is that these ratings don’t stay fixed forever. A company that looks rock-solid with an AAA rating today can slip to BBB or C tomorrow if its balance sheet weakens. When this happens, the value of its bonds can fall, and in turn, impact your returns.
This deterioration of bond quality significantly exposes you to many risks. Let’s examine those risks now.
Risks of directly investing in bonds
Bonds are vulnerable to mainly these types of risks: default risk, interest rate risk, liquidity risk, reinvestment risk, and concentration risk.
Imagine you buy a bond issued by a well-known company at 8% interest every year, and at maturity, you will get back your principal. What possibly could go wrong, right?
1. Credit risk (Default risk)
Let’s say, three years into your investment, the company begins to struggle with project delays and mounting debt. Suddenly, whispers about its ability to repay surface, and the rating agencies downgrade that bond. That’s credit risk (default risk), the possibility that the issuer may fail to give your money back.
Gensol Engineering in May 2025 faced severe financial stress due to project delays and rising debt, leading rating agencies to downgrade the company to a “D” rating, a clear example of default risk in action.
2. Interest rate risk
Now, picture this happening while interest rates in the broader economy are rising. New bonds are being issued at 9%, while yours still pays 8%. If you try to sell your bond before maturity, you will get a lower price because buyers would rather choose the new, higher-yield bonds. That’s interest rate risk.
3. Liquidity risk
Even if you decide to hold on, another problem may arise: what if you need cash urgently and want to sell your bond? Unlike stocks, bonds don’t always have ready buyers. This inability to sell it easily is liquidity risk.
Like in the Franklin Templeton case in April 2020, where the company had to voluntarily wind up its six debt schemes due to its liquidity issues.
4. Reinvestment risk
Now imagine the bond finally matures, and you receive your principal back. But interest rates in the market have dropped to 6%. If you want to reinvest, you will have to settle for lower returns. That’s the less obvious reinvestment risk.
5. Concentration risk
And finally, consider this: what if you had put most of your savings into this one company’s bond because it looked safe? The moment that the company falters, your entire portfolio feels the tremors. That’s the concentration risk, the danger of putting too many eggs in one basket.
For 8% returns, you are taking too many risks, but debt mutual funds have the potential to give you the same returns and that too with considerably lower risks.
How debt mutual funds can manage these risks
These funds exist for a reason. Many of the risks that come with buying a single bond can be managed more effectively in a mutual fund structure. Here’s how:
Credit risk (Default risk): In debt mutual funds, it invests across dozens of securities like government bonds, corporate debt, commercial papers, and treasury bills. So, if one issuer defaults, the risk is spread across the portfolio.
Interest rate risk: Fund managers actively monitor the interest rate environment. If rates are expected to rise, they can shift into shorter-duration bonds to reduce volatility. If rates are falling, they may hold longer maturities to lock in higher yields.
Liquidity risk: Unlike selling a single bond in the secondary market (which may not always find buyers), debt mutual funds give you the ability to redeem units on any business day. The fund itself manages liquidity by holding a mix of instruments.
Reinvestment risk: Since debt mutual funds continuously reinvest across multiple securities, they smooth out the impact of changing interest rates. You don’t face the problem of reinvesting a large lump sum at a lower rate.
Concentration risk: Rather than putting all your money into one or two issuers, debt mutual funds automatically diversify your exposure across sectors, maturities, and issuers.
A simple note: even debt mutual funds are not risk-free, but compared to owning a single bond directly, they offer broader safety nets and professional management that make them far less vulnerable to such risks.
Direct bonds vs. debt mutual funds
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Or, you can talk to a Qualified Financial Advisor (QFA), who will take time to understand your finanial orientation and personalize advice accordingly.
To sum up
After knowing all this, are you still thinking about directly investing in bonds? Bonds aren’t bad investments; they are an important part of any portfolio. But going directly into bonds without understanding the moving parts can be risky. Debt mutual funds give you the same exposure, but with professional management and diversification.
