Analysis: Fixed income options for you

Range of interest rates on fixed deposits for a period of 1-3 years

 Data Source: RBI

The initial steps

A challenge for you as an investor is to select investment options that match your goals. The goals will change over a period of time and this will also require you to vary the investment mix. Fixed income instruments either directly or indirectly through the mutual fund route will play an important role in the journey. The exposure to different instruments will have to change with the passage of time. In the example below earlier the exposure was mainly towards equities where the share was 60 per cent. With the passage of time and as the goals of children’s education and retirement came near the share of fixed income instruments went up resulting in a changed overall scenario. 

Example of asset allocation for an individual that reflects changes over a period of time

SuitabilityEvery part of your portfolio has to be created with a specific role in mind. Any goal that presents a situation where you cannot afford to fall short when the money is required like marriage expenses or education expenses for fees will require the use of fixed income instruments to meet the objectives. Conditions where you require a regular cash flow or have a fixed amount of earnings will also call for an effective use of these instruments.

RisksFixed income instruments are a stable investment option as compared to equities as massive changes in its value are likely to be absent. If the instrument is held till its time of maturity then the returns earned by you are easily predictable. However there are certain elements of risk that are present with a fixed income instrument. These risks will need specific steps so that they can be contained and this is something that you should pay specific attention to.

Credit riskCredit risk is a situation where the issuer of the fixed income instrument defaults and is unable to pay back the capital amount and even part of the interest due. This will be witnessed when the financial condition of the issuing entity deteriorates significantly. This situation poses a risk as you could end up losing capital on your investment. Issuing entities offer a higher rate of interest on instruments that have a lower credit quality so when you see higher rates make sure that you do your homework and understand the reason behind the high rate of interest. There are credit rating agencies which provide credit ratings for issuing entities and these should be checked before actually making the investment.

Reinvestment riskA common risk with a fixed income instrument is the ability of your money to keep earning the same or higher rate of return once the time period of the initial investment is over. This is known as a reinvestment risk. The fixed income instrument is in existence for specific time duration so when this time period ends and you look to reinvest the money if the available interest rates are lower than before then you could end up earning less than what you were earlier. There is also a possibility that you will earn higher than before but there is no guarantee that conditions will always be favourable for you.

If you take a careful look at the details of how your money was invested over a longer time period then there is chance that the situation looks something like the example below where a two year investment into fixed deposits is considered. The rate for the fixed deposit was initially at 6.5 per cent per annum for the first investment which was raised to 9 per cent for the next two years. After this the rate of interest rose further to 9.5 per cent and then to 10 per cent for the next two investment cycles. This was the peak as the rate then declined to 8 per cent when the next time to invest appeared. At every stage of the reinvestment  there was a risk about maintaining the existing rate of earnings and while there were times when this was successful there was also an occasion when you as an investor would have had to settle for lower earnings.

Interest rate on a 2 year fixed deposit over 10 years 

Inflation riskA fixed income instrument offers surety and confidence for you as an investor since the earnings in the form of interest are known at the time of making the investment. A 5 year bond issued by a financial institution might offer a rate of 8.25 per cent payable annually each year. Depending upon  the amount invested you know exactly the amount that you will earn as interest on the instrument. This comfort also gives rise to a risk as the purchasing power of the money could turn negative. Inflation which is the rise in the level of prices of goods and services reduces the purchasing power of money. Inflation will eat away at the earnings that you are generating on the fixed income instrument. The amount of inflation in future years is not known and there are times when this can rise sharply and if this goes higher than the rate of interest that you  earn then in real terms you are actually earning  a negative real rate of return.

The actual figures of annual inflation on the consumer price front in India climbed to 6.4 per cent in 2007 from 4.2 per cent in 2005. This rose further to 10.9 per cent in 2009 so if at that point if your fixed income instrument was earning a lower rate then the real rate of return was negative. This had come down to 8.9 per cent in 2011 but it still showed the challenge in ensuring that the earning rate  remained higher than the inflation rate. 

Consumer price inflation in India from 2002 to 2011

 Data Source: World Bank

Matching goalsPlanning for the long term can ensure that there is an effective  way in which you can achieve  your goals. If the details about your targets are known upfront then there  is a way in which you can plan  your investments by including fixed income instruments to achieve these goals. For example consider a situation where a sum of Rs 15,000 is required to achieve a goals of buying a specific consumer durable for the house. You can either set aside a sum out of your earnings and then buy it or invest a larger sum and make the purchase out of the earning of the instrument.  If the rate of interest prevailing is 9 per cent then you will require an investment of approximately Rs 1.67 lakh to generate the sum required to meet the goal.  This is better than an investment where you do not know whether the goal for the year will be achieved or not as the actual amounts could be higher or lower than the requirement.

Situation where actual earnings vary and pose challenge to achieving goals 

Benefits of fixed income investingLesser riskEvery investment comes along with a certain element of risk and reducing risk is a major goal for every investor. Using fixed income instruments directly or indirectly through the mutual fund route will lead to a reduced risk.  The standard deviation of income funds for example ranges from 0.12 to 3 which are far lesser than what you will experience for large cap equity oriented funds where the standard deviation is in the range of 16 to 21. Many instruments like fixed deposits are not traded which removes volatility in terms of daily changes or the need to look for its value on a regular basis. There is also a range of options to choose from and this range from government securities where there is no credit risk as the government stands behind the issuances to bonds issued by financial institutions where the strength of the entity acts as a comfort factor.  

DiversificationFixed income investments are debt instruments so they represent an asset class that is distinct from equities or commodities. This makes their movements independent to what several other assets are witnessing and it becomes a way for investors like you to diversify the risk faced in the portfolio.  Conditions that impact returns from fixed income instruments are different from what are faced by equity investments. This again reduces their relation and ability to change in a manner that affects the overall portfolio in a larger way. Diversification through holding fixed income instruments will ensure that you are able to grow the overall portfolio towards your specific goals.

Long term capital accumulationFixed income instruments ensure steady stream of earnings in the form of interest. As you start out on your investment journey in life this might look to be moderate in terms of earnings. With time on your side you can ensure that the benefit of compounding works in your favour. An investment of Rs 1 lakh earning 8 per cent per annum that is accumulated and reinvested might just give an earning of Rs 8,000 in the first year but it will become nearly Rs 16,000 by the tenth year and Rs 25,000 by the 16th year.  This massive rise in the absolute earnings over a period of time can be possible by simple discipline and it can yield you significant benefits in the later years.

How should I tackle this situation?Fixed income instruments are an asset class that cannot be ignored and as your portfolio grows the important of this instrument will also grow. Regular rebalancing of the portfolio to ensure that there is a specific weightage to these instruments is essential for every investor. Since there are a wide range of fixed income instruments you can also get exposure to several of them through the mutual fund route. This will enable you to control the risk that you face while investing and bring an element of stability to the overall portfolio. Ensure that an amount suitable for your specific requirements is invested in fixed income instruments.