Sunday, April 12, 2009

Fixed income investments

The asset classes – Debt or fixed income investments

I have earlier discussed the importance of asset allocation and the asset classes that typically form a part of an individual’s asset allocation plan, viz. stocks, real estate, debt and gold.

Debt

Debt is an asset class that lets one earn steady – and usually low- returns with little or no risk surrounding wither the capital or the returns. In an ideal world, debt returns would show little volatility too.

All sources that talk of debt investments talk of a few common things like the importance of retiring all high cost liabilities, like credit card loans and personal loans, the importance of having 3-6 months of expenses set aside in a liquid fund, so that one can draw the same down in case of an emergency, etc. All of that advice is well meant and one will do well to follow the same.

Risks

Contrary to what most of us assume, almost no investment option is completely risk free.

Interest rate risk

Even the safest option available to an individual investor, which is investment in government securities, suffers from interest rate risk. The value of a government security – or a GSec – tends to fall when interest rates rise and vice versa. So, there is risk of capital loss associated with investment in government securities, if the same are not held till maturity.

Credit risk

Investments like bank fixed deposits have what is called the credit risk associated with them. Credit risk is the possibility that the bank may go bust and one may not get ones money back.

Liquidity risk

Investments like post office deposits carry little credit risk as they are backed by the government, but suck away liquidity. One may not be able to withdraw the money when one wants, or may be able to do that, by paying a penalty that may be associated with premature withdrawal.

Reinvestment risk

There is also the reinvestment risk which means that one may not be able to reinvest the proceeds from ones investments – on maturity – in an avenue that gives the desired returns, if interest rates decrease.

Each one of the common products that one looks at suffers from one or more of the above. For instance, a bank fixed deposit, carries with it the credit risk, liquidity risk and reinvestment risk, while a post office deposit carries liquidity risk and reinvestment risk. Liquid mutual fund investments suffer from reinvestment risks while debt mutual fund investments suffer from most of the above mentioned risks.

There is no way one can remove all the risks and the best one can do will be to understand ones objectives and decide which of the risks one would be comfortable assuming.

Investment avenues

I classify the fixed income products available to on into two classes

The traditional products – like bank fixed deposits, government small savings schemes, debt/liquid mutual fund investments, etc. These are highly popular avenues. There are many websites that compare and contrast these avenues and as such I don’t intend to discuss those here. 

Outside of the above mentioned products, there are avenues like the equity arbitrage mutual funds and structured notes offered by some banks. These have characteristics similar to some of the traditional products and throw open the possibility of improving ones fixed income returns.

For instance, the equity arbitrage funds – which do not have the risk associated with equity markets, in spite of their name- have delivered 8-10% returns over the past couple of years. Given the fact that these are considered equity funds, they offer a tax arbitrage that is not available with traditional fixed income products.

I have recently come across structured products that promise the safety of capital and also guarantee a coupon – i.e. a fixed interest – while allowing one to participate in the upside offered by the equity markets, subject to certain conditions. Ofcourse there is no free lunch and one assumes the credit risk associated with the counterparty, which is a highly rated NBFC in the product I came across recently.

I will discuss these two options in greater detail, in a subsequent blog, as i believe they can help one improve on ones returns from fixed income investments significantly.

Return optimization

I think it’s very important that one seeks to optimize returns from fixed income investments, without assuming undue risks. Even a 1% annualized improvement in fixed income returns can help one get to ones financial objectives that much quicker. To achieve this one needs to be nimble. So, please dont convince yourself that you cannot do much with the returns from your fixed income investments. You will do well to ask your financial planner for his/her outlook on the debt markets on a periodic, say quarterly, basis and see if that warrants you to do anything with your investments. I know of people who moved into income funds around August/September and ended up with a 20-25% absolute return in 3-4 months time. While we may not be able to do this all the while, keeping ones eyes and ears open for opportunities like that doesn’t hurt.

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 


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