Debt as an investment avenue is regarded as a safe choice. The risks in debt markets are not immediately obvious. Yields have moved sharply this month, and volatility in debt markets continues. But, what role do risk and volatility play in debt markets?
Illiquid securities face little volatility, as there is almost no price discovery. It is difficult to enter or exit these investments and investors may have no choice but to hold them until maturity. While there is no fluctuation, there is risk.
Credit quality plays a central role in determining returns. Low quality pays a high price and vice-versa. The risk may be permanent loss of capital. Volatility arises from changes in ratings. Rating upgrades bode well for returns, while downgrades do the opposite.
New issues in the form of government or corporate borrowings are another potential source. The prices of older papers adjust to these new issues. If a security offers interest repayments above prevailing market rates, it is more attractive, and therefore will be priced higher than existing instruments of similar quality and tenor. The converse also holds true.
The RBI regulates debt markets using its monetary policy toolkit. Movements in the repo rate immediately reflect in debt markets, impacting long-term securities more than short-term ones. Even expectations of a rate hike or cut can induce volatility.
Price discovery drives volatility in equity markets. However, debt markets are influenced by credit quality, tenor, credit ratings, macroeconomic conditions, and speculative actions. Volatility in debt markets is expected to continue and is inevitable. At this juncture, it is important to build a portfolio that carries minimal volatility.