Skip to main content

Some strategies to beat the risks associated with Debt instruments

   Many investors take it for granted that returns from debt instruments are safe and reliable. The portfolio of a risk-averse investor is dominated by fixed income instruments. While the quantum of risk could vary significantly from equity investments, debt investments aren't entirely zero risk products.


   Rising interest rates has many investors flocking to lock their surplus in fixed instruments. However, before investing your hard earned money in fixed income instruments, you must judge whether you are prepared to take on the associated risks.
   
Here are some risks associated with debt instruments:

1) Interest rate risk    

The interest rate risk is the possibility of a change in interest rates that could eat into your returns. Returns on bonds, for instance, are directly impacted by interest rate fluctuations. There exists an inverse relation between interest rates and bond prices. If the interest rates rise, bond prices usually decline. If the interest rates decline, bond prices usually increase.


   New bonds are usually issued with higher yields as interest rates increase, making the old bonds less attractive.

2) Inflation risk    

With returns usually in single digits, a spiraling inflation could chew into your returns. So, your real returns could be far less than what is apparent. With inflation gradually marching upwards, the real returns on some old fixed instruments are actually negative.


   Assume a bank promises nine percent interest on your deposit per year. If the inflation rate is currently eight percent per year, then the real returns on your investment would be merely one percent.


   While the real value of your investment will climb up by only one percent during the one year period, imagine the predicament if inflation crosses into double digits. The real returns would be negative. Tax component, if considered, could reduce the real returns further.

3) Liquidity risk    

While fixed deposits are immune to interest rate risk, they are exposed to credit and liquidity risks. Credit risk arises when borrowers are unable to make payment of interest or principal in a timely manner. Bonds carry considerable risk of default that amounts to the inability of the issuer to make further income and principal payments.


   Another associated risk to consider is the liquidity risk.


   In essence, fixed income instruments are not the guaranteed products that they appear to be. If you do not research well before investing, you could end up with peanuts in your portfolio.
   
So tips for investors in debt products:

1) Look for new avenues    

Explore beyond traditional products that are novel and promise higher returns. A wide platter of options is available in debt mutual funds that vary in terms of risk-returns, liquidity and safety.


   You can select from short term funds, money market funds, gilt funds, fixed monthly income plans and so on based on your risk profile and asset allocation strategy. Returns on short term funds are on par with fixed deposits. Factor in the exit load and other charges when assessing returns from these funds.

2) Consider laddering    

In an increasing interest rate scenario, it becomes difficult for an investor to judge the best time to lock his money in fixed deposits. What if the rates climb higher tomorrow?


   In laddering, instead of locking your entire money in one fixed deposit, break it into smaller portions and lock them in different deposits having different maturity dates. This technique helps reduce the adverse impact of rate fluctuations, increases liquidity and draws maximum returns.


   What if the rates fall? You can be glad you have locked a portion of the surplus at higher rates.

3) Fixed maturity plans    

Fixed maturity plans (FMPs) that invest in high quality bonds are a safe bet. With tenures ranging from 3-15 months, these plans hold the bonds till maturity. Hence, certainty of returns is assured in case of FMPs.

4) Rebalance periodically    

Dimensions including risk appetite, liquidity needs and age impact an investment pattern. As one grows older, the quantum of risk he is willing to take shrinks. Further, relative asset allocation between fixed returns instruments, equity, real estate and precious metals changes with time. Rebalance your portfolio periodically to regain the original asset allocation.

5) Diversify    

Build a well-diversified portfolio with a mix of both safe and high risk-returns products. Even if you are risk-averse, a small exposure to equity is not a bad idea, especially in times of high inflation.
 

Popular posts from this blog

All about "Derivatives"

What are derivatives? Derivatives are financial instruments, which as the name suggests, derive their value from another asset — called the underlying. What are the typical underlying assets? Any asset, whose price is dynamic, probably has a derivative contract today. The most popular ones being stocks, indices, precious metals, commodities, agro products, currencies, etc. Why were they invented? In an increasingly dynamic world, prices of virtually all assets keep changing, thereby exposing participants to price risks. Hence, derivatives were invented to negate these price fluctuations. For example, a wheat farmer expects to sell his crop at the current price of Rs 10/kg and make profits of Rs 2/kg. But, by the time his crop is ready, the price of wheat may have gone down to Rs 5/kg, making him sell his crop at a loss of Rs 3/kg. In order to avoid this, he may enter into a forward contract, agreeing to sell wheat at Rs 10/ kg, right at the outset. So, even if the price of wheat falls ...
Read more

SBI bonds FAQ

  Maximum retail subscription and over – subscription There is a lot of excitement around these bonds, so I won't be surprised if they get over-subscribed on the first day itself. So, I thought Sameer asked a very good question about over-subscription. Here is that discussion. Here are some other questions that you may find useful. Can I trade the SBI bonds on NSE after it lists? Yes, these can be traded after listing. Where can I get the application forms, and can I buy the bonds online? You can get the application from notified branches, and then fill it up there and submit it. To the best of my knowledge, there is no way to invest in them online, but if anyone knows otherwise then please leave a message, and let us know. Can NRIs apply for these bonds? NRIs can't apply for these bonds as they fall under one of the ineligible categories. Can you take a loan by keeping the SBI bonds as security? The terms of the issue in the prospectus state that the bank shall no...
Read more

ICICI Prudential Balanced Fund

 ICICI Prudential Balanced Fund scheme seeks to generate long-term capital appreciation and current income by investing in a portfolio that is investing in equities and related securities as well as fixed income and money market securities. The approximate allocation to equity would be in the range of 60-80 per cent with a minimum of 51 per cent, and the approximate debt allocation is 40-49 per cent, with a minimum of 20 per cent. An impressive show in the last couple of years has propelled this fund from a three-star to a four-star rating. The fund has traditionally featured a high equity allocation, hovering at well over 70 per cent, which is higher than the allocations of the peers. But in the last one year, the allocation has been moderated from 78-79 per cent levels to 66-67 per cent of the portfolio. ICICI Prudential Balanced Fund appears to practise some degree of tactical allocation based on market valuations. Within equities, well over two-thirds of the allocation is parked i...
Read more

Fortis Mutual Fund

Fortis Mutual Fund, a relatively new player, it is still to prove its case and define its position in the industry. In September 2004, it came onto the scene with a bang - three debt schemes, one MIP and one diversified equity scheme. And investors flocked to it. Going by the standards at that time, it had a great start in terms of garnering money. Mopping up over Rs 2,000 crore in five schemes was not bad at all. The fund house has not been too successful in the equity arena, in terms of assets. Though it has seven equity schemes, it is debt and cash funds that corner the major portion of the assets. Most of the schemes are pretty new, and the two that have been around for a while have a 3-star rating each. The last two were Fortis Sustainable Development (April 2007), which received a rather poor response, and Fortis China India (October 2007). Fortis Flexi Debt has been one of the better performing funds, after a dismal performance in 2005. It currently has a 5-star rating. None ...
Read more

Equity investors should track market developments

The stock markets have been volatile over the last few days. They are in a sideways movement and trying to find the bottom after a fall of 20 percent a week ago. The market sentiments are not very positive at the moment and the recent developments are expected to dampen them further. Globally, governments and central banks are trying to cut rates and announce packages to improve business sentiments. These are some of the major developments in the markets last few month: A) Global On the global front, another large US bank went into a financial crisis. The US government took quick measures to avoid the spread negative sentiments in the markets. The US government announced a bail-out package and agreed to shoulder the losses on the bank's risky assets. China announced a large cut in interest rates and reserve ratio to boost the investor sentiments in the markets. Recently, the World Bank announced China's growth rate next year will come down to 7.5 percent. The European ...
Read more
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now