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.
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