By Sunil K Parameswaran
Conservative investors, by which we mean relatively risk-averse investors, prefer investments in debt securities to investments in equity shares. The former are considered safer, because creditors enjoy priority over shareholders if a company were to get into financial trouble. Therefore, debt securities generally yield lower returns than equity shares. But there are many shades of debt.
Credit rating agencies like CRISIL rate debt issues. While AAA and AA rated securities are considered to be very safe, non-investment grade or junk bonds are extremely risky. Historical data revealed that in the US not a single AAA rated security missed a payment in the first year after issue, over a period of more than 80 years.
Treasury securities like T-bills, T-notes and T-bonds are safer since they are backed by the full faith and credit of the central or federal government. However, like corporate debt, G-Secs too are vulnerable to reinvestment risk from the standpoint of coupons, and market risk or price risk if the security is sold prior to maturity. Government securities score over corporate debt from another perspective as well, for they are usually more liquid.
It is not necessary that a security should be negotiable from the perspective of liquidity. For instance, National Savings Certificates (NSCs), are not negotiable, but an investor can pledge securities and borrow. Many investors consider bank fixed deposits to be safe investments, particularly in India where most leading banks are owned by the government. But with the government trying to keep an arm’s length from the corporate sector, which includes the banking sector, it remains to be seen as to what extent a country’s government will go to bail out troubled banks, even if they are in the public sector. One positive development is the increase in the insurance limit under Deposit Insurance Credit Guarantee Cooperation for bank deposits in India from Rs 1lakh to Rs 5 lakh.
Debt mutual funds
Debt mutual funds are an alternative to bank deposits. Liquid funds, ultra short duration bond funds, and short duration bond funds pose relatively less price risk. And such funds hold a diversified portfolio of debt securities, which reduces default risk. In a mutual fund, an investor can opt for a growth, dividend, or dividend reinvestment option depending on her requirements. From a tax angle such investments may be better because they provide the benefit of indexation to unitholders.
In markets where mortgage backed securities, which became famous due to the 2008 financial crisis, are available, investors get monthly pay outs. Unlike bonds which make a bullet repayment of the principal at maturity, in a mortgage loan, a certain amount of principal is repaid every month. Amortised bonds are also an option for investors who want to reduce default risk, since such bonds return the principal in instalments, starting well before maturity. Bond insurance, if available, is also an option to reduce risk.
Retired people rely heavily on debt for financial security. They should be well aware of the options available to them, and their relative risk factors. Such investors need to keep abreast of tax regulations, and their implications for their income.
The writer is CEO, Tarheel Consultancy Services