Identifying risk in fixed income securities
Jitendra Solanki of JS Financial Advisors discusses the risks associated with fixed income securities.
JS Financial Advisors
For small investors, fixed income investment largely hovers around FDs, RDs and Post Office schemes. They hardly think of investing in Debt Mutual funds or any other variable income instruments. The primary reason for this is the lack of understanding on risk and return characteristics of these instruments.
But lately, we have seen products like NCDs, FMPs and other debt products catching the eyes of these investors. The attraction is surely the higher yield or returns generated by these instruments in last few years. But before committing any money to fixed income products, its wiser to understand what are the risks present in them and how does they impact the net returns you earn.
1. Interest Rate Risk- The bigger impact on fixed income securities is from interest rate movements. The prices of these securities behave inversely to the interest rate. So when interest rate moves up the prices of such securities falls along with it. This happens because when there are new securities available at higher prices offering higher yield, the older securities lose interest among the investors.
Due to this impact the market aims to align the prices of these securities to match the higher yield. Similarly, when interest rate moves downward the prices of securities move up. Hence the prices of securities carry a higher volatility with the interest rate movement and so the returns from the debt mutual funds investment which invest in these securities are impacted whenever interest rates rise or fall.
2. Reinvestment Risk- A reinvestment risk emanates when the security in which you invested earlier at is not able to fetch the same returns when it is matured and need to be reinvested. This generally happens when the interest rates moves downwards which forces investors to look for higher yield instruments.
3. Credit Risk- In any fixed income security the repayment of the principal back to the investor rely heavily on the credibility of the company issuing it. If the company financials are not sound and defaults, the investor may lose the capital also.
Such companies find it difficult to raise money from the public due to credit quality and so they offer high interest rates to investors to compensate for it. Corporate Deposits and NCDs offering higher rates are example of these investments.
Since these issues are rated by the agencies, a high credit rating signifies the safety of principal but will offer lower yields to investors. Contrary to this, a lower rating security will carry high risk of default but will offer higher yield.
4. Price Risk- In current scenario most fixed income securities are listed on exchanges and traded. In some category of investment this is the only window available to the investors who want to exit before maturity.
The price on the exchanges is an impact of interest rate movement and the volumes of trading activity. There is always a risk of lower liquidity in such securities which leads to investors not receiving a good price and so the yield is far lower then expected.
5. Purchasing Power Risk- This risk results when yield from a fixed income security is not able to beat the inflation. Since gains from most fixed income securities are taxable, the net return is what is received after paying taxes on the gains. Any security which offers a lower interest rate or yield will get impacted by the taxation and so the net returns is either matching inflation or not able to beat it.
Fixed Deposits, Recurring Deposits or other investment offering a fixed rate to investors are most affected by this risk. When the net returns are lower it reduces the purchasing power of the investment which an investor would have earmarked for achieving some goal in the future.
These are most common risk present in fixed income securities which impact the net yield investor earns from them. Since it’s difficult for a small investor to predict the interest rate movement, It’s wiser to not get swayed by the returns alone and analyze the impact on the objectives before making any investment decision.
The author is a CFP & Founder of JS Financial Advisors.