Nothing Fixed About Fixed Income. Here's why

Rajendra Kalur

Mr. Shroff came home last Saturday from a dinner a worried man. It all happened when Mr. Shroff was introduced to a Registered Investment Advisor. Several people were around the RIA and amidst the clinking of cocktail glasses, all wanted to know the fate of equity market especially with talks of US rate hike, De-globalisation, Chinese slowdown etc. Like always, nobody seemed interested about the debt market. Mr. Shroff remained quiet with a smug feeling that his portfolio of 100 percent fixed income can’t go wrong.

This feeling lasted for a few moments till the RIA asked him as to how he managed his portfolio. Mr. Shroff calmly explained that being risk averse he has invested his surplus in various fixed income instruments and is insulated from the shocks of the equity market.

A simple expression from the RIA that there’s nothing “fixed” about fixed income jolted him out of his complacency. In a quick turnaround Mr. Shroff sought an appointment for the very next day to get his portfolio analysed and understand the various nuances of managing a fixed income portfolio. What followed was a fascinating journey into the world of Fixed Income and it unravelled a completely new world for Mr. Shroff.

Let us see what it is. That day Mr. Shroff learned that fixed income instrument neither guarantees a return nor the principal and both are subject to interest rate risk and credit risk respectively. Mr. Shroff also learnt that high yielding instrument doesn’t mean a higher coupon at a lower risk: rather it means an opportunity to get a higher coupon on an unrated or a lower credit instrument. He also learnt that it’s not all hunky dory in a declining interest rate regime. Rather the returns are impacted by the duration and composition of the portfolio.

While selling a fixed income instrument may yield capital gains, these are not only subject to capital gains tax but also face a reinvestment risk. As the RIA meticulously took Mr. Shroff through the construction of the yield curve, term structure, credit spreads, ZCBs or Zero Coupon Bonds, Bond yield and the difference between coupon rate and Bond yield, dirty and clean pricing, he quickly gulped a few glasses of water.

Not only was the fixed income world made of several moving parts, it is a fairly complex maze which can be deconstructed by one who is well versed with the industry. At the end of the meeting, Mr. Shroff requested for a second one: This one to specifically review his portfolio and analyse it on the basis Safety, Liquidity and Returns together with decomposing it on the basis of Credit, Duration and Reinvestment risk.

RIA promised to evaluate the portfolio and also recommend an optimal way of managing the seemingly impossible trinity of Safety, Liquidity and Returns. What we see is a reflection of the low level of awareness of fixed income investments not just amongst the retail community but also amongst the relatively more affluent.

Many investors go into fixed income investment with eyes closed and ill prepared for any negative news. No wonder that the shock level is higher when a fixed income instrument goes bad as compared to loss of capital in equity. Hence, my recommendation is to go for competent, experienced and conflict free advice: who better than a RIA to do that.

Author is CFA Charterholder, Founder Director & CEO, TrustPlutus Wealth Managers (India)