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How should you compare Fixed Income Instruments?

 

 

When choosing fixed income investments, investors often end up comparing the past with the future. This sounds like a strange mistake to make but investors do it inadvertently. However, it's still something that can mislead them and result in the wrong (or at least sub-optimal) investment decisions.

 

How this happens is actually straightforward. When you're looking to choose a fixed income investment, you have a range of options to choose from a range of different options. Typically, you would compare bank deposits, fixed income mutual funds (both open-end and fixed maturity FMPs, and a few others. Functionally, in terms of what they deliver to the investor, these are close alternatives. However, they work in very different ways. Bank (or company) fixed deposits are guaranteed instruments where you are told what you will earn over the coming times.

 

Fixed income mutual funds, and other market-based instruments cannot tell you what they will earn in the future. Instead, you typically make a choice based on what the same fund, or that type of fund earned in the past. This can make a big difference, and the difference is particularly important when interest rates are changing, as they are now—or indeed, as they have been doing so almost continuously for many years now.

 

Fixed deposit rates for a one year term are 10 per cent or a little more. However, if you look at the one-year return for the various shorter-term debt funds on ValueResearchOnline.com, the catgeories' average ranges from 7.4 to 8 per cent. Does that mean that debt mutual funds are going to earn that much less than bank deposits? Not quite. It just means that you are comparing the past with the future. The fund returns are the actual returns over the past one year. The FD returns are what will be delivered over the next one year. For fixed income investors 1 or two per cent is a big differential. However, to get the right answers, one needs to make sure that one is not making an apples to oranges comparison.

 

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