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

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

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

Gold: It is safe & secure

RETURNS ON GOLD & ITS ETF’s RISE WHILE most of the popular asset classes are going through bad times, the yellow metal shines on. In fact, in the last one year, gold has given a return of more than 25% and currently trades at Rs 14,695 per 10 gm. Even gold exchange traded funds ( ETFs ) have appreciated substantially. Gold Gold Benchmark Exchange Traded Scheme ( BeES ) and Kotak Gold ETF have given more than 25% returns each in the last three months. Even as the equity markets have taken a hit with the Sensex losing around 46% in the last one year and real estate prices also witness a correction, investors’ preference has shifted to safe havens such as gold. On an average, most of the diversified equity mutual funds have fallen and real estate developers are offering discounts. Thus gold remains the safest bet. The appreciation in the gold prices is mainly due to its safe haven status. The key reason for gold to go up is lack of other investment opportunity. There is also a risk in...
Read more

More on Mutual Funds

What Is a Mutual Fund ? A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Anybody with an investable surplus of as little as a few thousand rupees can invest in Mutual Funds. These investors buy units of a particular Mutual Fund scheme that has a defined investment objective and strategy The money thus collected is then invested by the fund manager in different types of securities. These could range from shares to debentures to money market instruments, depending upon the scheme's stated objectives. The income earned through these investments and the capital appreciation realized by the scheme are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.   What Are The Types of Mutual Fund Scheme...
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