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It’s a misconception that FD, RBI Bond, PPF etc have no risk. The reason we don’t see the risk in them is because for us, risk ONLY means loss of capital.
This article intends to educate you on the risks in fixed income investing & the right product mix to invest in within fixed income, depending on your risk profile.
(1) There are 3 risks to keep in mind while we do fixed income investing
(a) Default Risk – Investment has a risk of default. You might not get paid the interest or your capital may not come back in full. FD, RBI Bonds, PPF generally may not have this risks but corporate FD’s do.
(b) Interest Rate Risk – After you invest, Interest rates going up or down can also be a risk.
(i) Imagine investing in a bank FD for 5 years at 5% right now & a year later interest rates go up, you will still keep receiving the same 5% & not the increased rate, this is a risk.
(ii) Investing in an FD at the peak of say 8% for 1 year & after 1 year when you receive the maturity & you try & reinvest, the rate on the new FD is lower say 6%, this is also a risk, re-investment risk. FD, RBI Bonds, PPF – Have this risk.
(c) Liquidity – How soon can you get your investment back at fair value?
Lets say if you invest in a PPF, lock-in theoretically is 15 years. If you invest in a bank FD for 5 years & try removing before 5 years, there will be a penalty. Again FD, RBI Bond, PPF all has this risk.
(2) What should investors do?
Investors first have to decide which risk are they willing to take. Each instrument will have some or the other risk. Like say,
(a) Fixed Deposit – Has Interest rate risk & liquidity risk
(b) Corporate Deposits – Has all 3
(c) Government Securities – Liquidity & Interest rate risk
(d) Mutual Funds – All 3 risks are expected to be managed well, provided you have picked the right scheme depending on your requirement.
Nothing in fixed income is fixed and everything has risk. You have to decide which and how much of the risk are you comfortable with.
(3) How do you access risk? What do you keep in mind?
For me, investors should follow an asset allocation strategy. Lets say I am a conservative investors, I will invest 80% in debt and 20% in equity. Now the point here is don’t invest all 80% of debt in the same category/product. Split the 80% into 3 different buckets,
(a) Liquidity portfolio – This is the portfolio, which allows you to have liquidity whenever required. 10% of your debt portfolio can be here (80% * 10% = 8%)
(b) Core debt portfolio – This portfolio is the main portfolio investment. Depending on your requirement in terms of risk and return, 70% of your debt portfolio can be here (80% * 70% = 56%)
(c) Tactical portfolio – Here is where some tactical call on debt can be taken to generate slightly superior returns on the portfolio. 20% of your debt portfolio can be here. (80% * 20% = 16%)
(4) So what falls in Liquid, core and tactical portfolio?
| Conservative Investor | Moderate Investor | Aggressive Investor | |
|---|---|---|---|
| Asset Allocation | 80% Debt – 20% Equity | 50% Debt – 50% Equity | 20% Debt – 80% Equity |
| Liquid Portfolio (10%) | Liquid funds | Liquid funds | Liquid Fund or Ultra Short Term Funds |
| Core Portfolio (70%) | Post Office Schemes | Corporate Deposits, PPF, Low duration funds | Short Term Funds, Medium Term Funds |
| Tactical Portfolio (20%) | Corporate Deposits, Low Duration Funds | Short Term Funds, Corporate Bond Funds | GILT, Credit Risk Funds |
This is a representative portfolio and not an investment advice.
(5) Why so much of MF suggestion?
MF’s in my opinion will be able to offer a better risk adjusted return. Ofcourse we can argue Franklins case here but generally I would prefer an MF to most other products,
(a) Liquidity is available in T+1 days
(b) Interest rate risk – There are multiple schemes to choose from where this can be controlled.
(c) Default – Each scheme invests in 50+ bonds roughly, even if 1 bond defaults the over all impact is less
(d) Tax – If we stay invested for 3 or more years, the tax advantage is superb. If we invest in an FD earning 6% and we are in the 30% tax bracket, the post tax return will be 4.2% but if an MF earns 6% (everything else same) and inflation is 5%, MF investors are taxed 20% only on the differential 6% – 5% = 1% * 20% = 0.2%. So the net return I make is 6% – 0.2% = 5.8% vs 4.2% in an FD.
(6) What can be recommended to a senior citizen right now?
(a) Senior citizen savings scheme – 7.4%
(b) LIC Pradhan Mantri Vaya Vandana Yojana (PMVVY) scheme – 7.4%
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Nothing in this article should be constructed as investment advice; readers are advised to consult their distributors before making any investment decisions.