Every fixed-income investor will have to live with interest rate risk. In a falling interest rate scenario, the investor has to bear the lower rates
The year 2015-16 has been eventful for both equity and debt instruments. Banks have declared the list of wilful defaulters and there were downgrades of credit papers of major corporates, which had a ripple effect on debt mutual fund investments outlook. Markets regulator Sebi came out with more detailed instructions on the credit ratings being carried out by mutual fund houses.
In such a scenario, it is very important that an investor must know the instruments he chooses to invest. One must know the quality of underlying papers invested by the fund houses. As a double whammy, the government reduced the interest rates on all small savings schemes. They were very popular, especially among senior citizens, for assured returns. So, how do you ensure that the returns are not subject to surprises and there is certainty of income.
Checklist for investment
While investing in debt instruments, it is important to know where the money is invested. High returns excite all and it is the main factor that most investors consider. Investors must look at credit risk. If there is a possibility of the principal amount not being returned back, the existence of credit risk is prevalent. Credit risk also could be a default risk. The risk of the corporate defaulting in its commitment of payment is a risk that must be considered before making investments.
Is there a way we can mitigate the risk of default and credit risk? Credit rating agencies come out with credit ratings of various instruments. Again this is not a 100% accurate method, as the ratings can be downgraded/ upgraded based on the financial performance of the corporates.
Liquidity is another factor which you must consider while investing in debt instruments. For a layman, it is the possibility of not getting the principal back at the pre-determined time or getting the principal amount back, albeit at a discount. The loss or haircut is not acceptable to any investor. Liquidity is basically the cash flow you need and short-term requirements should not be earmarked to long-term instruments. If you have a cash flow requirement in three months’ time, you will not try to invest in accrual funds, with paper having a maturity of 18 months.
Every fixed-income investor will have to live with interest rate risk. In a falling interest rate scenario, the investor has to bear the lower rates. This becomes more prevalent at the time of reinvestment. This is where you need to plan for time horizon required in your investment instruments.
How do you tackle the interest rate risk? Holding the instruments till maturity. Irrespective of the interest rate movements you will continue to get the rate offered at issuance. But then you still carry the risk at the time of reinvestment/maturity if the rates fall.
Inflation risk is in-built in the investment and there is no hiding from it. The longer the tenure of the instrument, the higher the exposure to the risk. To counter inflation risk, one must look at the asset allocation strategy.
In investing, once you know, which road not to take, it becomes all the more easier. The basic checklist will help you to take informed decision in the investment process. When investing for short term, liquidity is the key measure. You need to have the money, when you need it without any haircut. For investing in longer time frames, regularity and certainty of cash flow must be considered. Inflation risk and reinvestment risk are inherent and cannot be done away with.
Risk is inherent in investing, the nature of asset class, being agnostic. Knowing why we are investing and prior knowledge and information of the risks associated with the investments is the approach to execute. What is, however, observed is the exact opposite – first invest and then worry.
The writer is founder & managing partner, BellWether Advisors