Fixed income investments – Benefits and risks of these investments

Updated: June 03, 2021 6:37 PM

Asset allocation means dividing your portfolio into various asset classes as per your goals, investment horizon, and risk appetite. Equities, fixed income, real estate, and cash are a few of the major asset classes that most of us deploy in our portfolio.

fixed deposit, FD, bank fixed deposit, DICGC, deposit insurance, RBI, Interest income, tax saving FD,  secured cards, loan against FD, TDS, tax liability, tax deductions under Section 80C, Options for Senior Citizens, fixed income Options for Senior Citizens, lower tax bracket,Regular bonds, Tax-free bonds, Post office schemes, Bank deposits, Pradhan Mantri Vaya Vandana Yojana, RBI Savings Bond, post office national savings certificate know interest rate tenure features, 2021 Post Office interest rates, small savings schemes, National Savings Certificates, KVP, Time-deposits, Public Provident Fund, Senior Citizens Savings Scheme, Sukanya Samriddhi Yojana, features, Options for Senior Citizens, fixed income Options for Senior Citizens, lower tax bracket,Regular bonds, Tax-free bonds, Post office schemes, Bank deposits, Pradhan Mantri Vaya Vandana Yojana, RBI Savings BondWithin the fixed income universe, some assets can give attractive risk-adjusted returns to the investors.

Investing is not just Accounting or Math. It is a mixture of Psychology, Philosophy, Art, and Science. If there were just a mathematical formula for it, we would be now sitting on a pot of gold.

Increasing your investments’ success chances against all odds is the art of not putting all your money in one basket.

Often, a lot of time is spent analyzing individual investment opportunities (a stock, debt fund, bitcoin!). However, investors often ignore the most crucial investment process element: Asset Allocation.

Asset allocation means dividing your portfolio into various asset classes as per your goals, investment horizon, and risk appetite. Equities, fixed income, real estate, and cash are a few of the major asset classes that most of us deploy in our portfolio.

There’s more to Fixed Income than “Papa ki FD”- not every fixed-income instrument is guaranteed; some may even involve risks. So fixed-income investments – These are assets that pay fixed returns on your investment in the form of interest and return the principal after a certain amount of time.

Some examples of such assets can be:

  • When you invest Rs 1 lakh in a bank FD bearing 5% interest for three years, the bank promises to pay Rs 5,000 as interest every year and promises to repay the principal at the end of three years. In this example, ₹5,000 is a fixed obligation of the bank, and the obligation is not dependent on any market parameter.
  • Many companies also issue fixed-income securities called bonds to raise money. These securities have a defined coupon rate which is the interest you get for investing in the bond. These bonds also have a maturity date when the principal returns to the investor. Hence bonds are also examples of fixed-income investments.
  • Fixed-income assets usually are debt obligations of the issuer, i.e., when you invest in these securities, you lend money to the issuer. Issuer (borrower) can be a government entity (including govt institutions) or a private entity (for example, private banks, corporates, etc.)
  • These assets differ from equity instruments wherein an investor gets ownership of the underlying issuer. For example, when you invest in a company’s stock, you become a fractional owner of the company. In contrast, if you invest in the same company’s bond, you effectively become their lender. However, in the scenario that the issuer was to go bankrupt, fixed-income investors have a higher priority over equity investors. Let’s say a company had issued fixed income securities (bonds) of 100 Cr and had raised 200 Cr as equity. Now let’s say the company becomes bankrupt, and after selling its assets, the recovery is only 150 Cr. Out of this 150 Cr, a complete 100 Cr will go to the fixed income investors while only 50Cr will go to the equity investors. Since fixed-income investors have much lower risk than equity investors, the returns also tend to be lower than equity investments.

Benefits of Fixed Income Investments:

Diversification: Fixed income assets have a low correlation with equity. This means that the value of your fixed-income investment is not linked to stock market performance (e.g., bank FD rates will not fall because the stock market has crashed); hence they provide stability to your portfolio by offsetting any losses, which maybe they’re in the equity portion of the portfolio.

Lower risks: Fixed income investments usually are safer than equities. Firstly, the returns are fixed and not volatile like equity returns, and Secondly, even in the case of an issuer bankruptcy, fixed-income investors have a higher preference than equity investors. This makes such an investment attractive for investors who have a lower risk appetite.

Steady Stream of Income: Fixed income securities generate a regular stream of cash flows for the investors. Further, the amount and timing of these cash flows are also known in advance, helping the investors plan their finances.

Returns: Within the fixed income universe, some assets can give attractive risk-adjusted returns to the investors.

Risks in fixed-income investments:

Credit Risk: As discussed above, government institutions or private entities can issue fixed-income assets. The risk of government defaulting is zero; however, it is not valid for private entities. Thus, investors are exposed to the issuer’s credit risk in securities issued by private entities (banks, corporates, etc.).Hence, understanding the investment’s credit profile is essential before investing in such products.

Interest Rate Risk: Let’s say an investor, Raju invests in a government bond that gives a 6% coupon for the next ten years and pays bank principal at the end. Due to changes in the macroeconomic(whole country’s economy) conditions, RBI increases Repo Rates(The rate at which RBI lends money to banks during the shortage of funds), increasing its prevailing interest rates. This government also has to increase the coupon rate it offers for fresh borrowings via government bonds – let’s say this coupon rate is 8%. While fresh investors in new government bonds would get higher coupons of 8%, Raju still receives a lower 6% coupon. This 6% coupon may not be sufficient to beat prevailing inflation rates. Let’s say, Raju, after holding the bond for a year, wants to sell the same(with a remaining maturity of nine years) in the secondary market. Since the new government bonds offer 8% rates, Raju would need to sell his bond at a discount so that the bond buyer receives 8% interest on his investment. This discount will roughly translate to the difference between the new coupon rate and the initial coupon rate multiplied by the bonds remaining tenor, i.e. (8%-6%)*9 = 18%. Thus Raju would receive approximately Rs 82 for a Rs 100 principal investment if he chooses to sell his bond.

Liquidity Risk

Some fixed-income investments may be either:

  • Illiquid in nature, i.e., there may not be an active market where the investors can sell their investment.
  • May have a lock-in period before which an investor cannot exit (examples of this can be your public provident fund investments – we will discuss in more detail in our subsequent articles)
  • May have penalties for premature withdrawal or exit loads (examples fixed deposits)

Fixed Income Investment Options

We have discussed what fixed-income investment means, its benefits, and the associated risks. Various fixed income investment options available to retail investors have been depicted below in tabular format. These have been classified into two categories

1) Fixed income investments backed by the government, thus having negligible credit risk.

2) Fixed income investments issued by private entities and are subject to credit risk.

by, Ajinkya Kulkarni, Co-founder of Wint Wealth

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