Indians love the word ‘guaranteed’. A guarantee is an unbreakable promise of trust. This partly explains why fixed income products are such a great hit. It doesn’t matter if the Sun rises from the West tomorrow, but a fixed income investment product is supposed to deliver what it promises. Right from bank deposits, small-saving schemes, annuities to larger schemes, the ‘fixed’ element gives investors a sense of comfort and assurance. When the fixed income returns are high enough, the need to invest in other avenues by assuming higher risk is almost non-existent. But, the fact is fixed income investing needs to be carefully done. If you do not pay attention to the key factors, even fixed income may disappoint you. Read on to know why.
The basic reason behind any financial investment is to get a reasonable return. Since prices of goods and services are going up every year, it is important to keep the inflation in mind while looking at the return. A reasonable return, in this context, is a number that beats inflation. Unfortunately, not all fixed income avenues beat inflation. When the price rise is high, fixed income instruments find it very difficult to generate more returns than inflation. Any return below inflation means that you are losing money. You may earn 5% guaranteed return, but if the inflation is 6%, you are losing 1% of your money. Therefore, it is important to invest in fixed income options that have a track record of matching or giving more than inflation. Without your fixed income return beating the inflation rate, the power of your investments would erode.
Since fixed income avenues do not involve any great risk, tax laws do not allow one to be lightly taxed. Fixed income is practically assured return. Because of this, we must remember that fixed income gains can be taxed at the individual’s tax slab. At a higher tax slab, gains from fixed income can be heavily taxed. This would make them extremely unattractive on a post-tax return basis. Any fixed income avenue that allows you to get the benefit of indexation is a better option than a flat tax rate. Indexation reduces the tax burden. For senior citizens who rely on fixed income avenues to get a regular income, taxes must be planned meticulously. This is because taxes eat into the potential return. Any tax benefit adds to your fixed income returns and ultimately to your wealth. Hence, it is extremely important to plan your taxes while using fixed income strategies. The entire approach must be proactive, then reactive solutions which when taken haste can even compound problems.
Many products today use fixed income structures to guarantee part or full returns of the investments. Liquidity crisis, credit crunch and asset-liability mismatches are common today. A fixed income is a guarantee. However, the income that you will derive from these assets should be strong enough to sustain regular pay-outs. We have already seen how weaker finance companies etc. can face a lot of problems during debt repayment. A slight deviation from the pay-out structure or repayment date can throw your plans off gear. So, it is very important to see how good the underlying assets are. If the assets are good and liquid, there will be money around the corner to repay. Just blindly trusting a third party for fixed income is right? No. There will be signals and enough information to tell you how asset invested will behave if there is a crash in such asset prices. Keep a close watch.
(By Anil Rego, Founder and CEO, Right Horizons)