Investing isn’t just about accounting or math. It is a mixture of psychology, philosophy, art and science. If there was only one mathematical formula for this, we would now be sitting on a pot of gold.
Increasing the chances of your investments succeeding against all odds is the art of not putting all your money in one basket.
Often a lot of time is spent analyzing individual investment opportunities (a stock, a debt fund, a bitcoin!). However, investors often ignore the most crucial element of the investment process: asset allocation.
Asset allocation involves dividing your portfolio into different asset classes based on your objectives, your investment horizon and your risk appetite. Some of the major asset classes that most of us deploy in our portfolio are stocks, fixed income, real estate and cash.
Fixed income securities are not limited to “Papa ki FD”: not all fixed income instruments are guaranteed; some may even involve risks. So, Fixed Income Investments – These are assets that pay fixed returns on your investment in the form of interest and return the capital after a certain period of time.
Some examples of such assets can be:
- When you invest Rs 1 lakh in a FD bank bearing 5% interest for three years, the bank undertakes to pay Rs 5,000 as interest each year and undertakes to repay the principal after three years . In this example, 5,000 is a fixed bank bond, and the bond does not depend on any market parameter.
- Many companies also issue fixed income securities called bonds to raise funds. These securities have a set coupon rate which is the interest you get by investing in the bond. These bonds also have a maturity date when the capital returns to the investor. Therefore, bonds are also examples of fixed income investments.
- Fixed income assets are typically debt securities of the issuer, that is, when you invest in those securities, you are lending money to the issuer. The issuer (borrower) can be a government entity (including government institutions) or a private entity (eg private banks, corporations, etc.)
- These assets are different from equity instruments in which an investor becomes the owner of the underlying issuer. For example, when you invest in the shares of a company, you become a fractional owner of the company. On the other hand, if you invest in the bond of the same company, you effectively become its lender. However, in the event that the issuer goes bankrupt, fixed income investors have a higher priority than equity investors. Let’s say a company issued fixed income securities (bonds) of 100 Cr and raised 200 Cr in the form of equity. Now suppose the company goes bankrupt and after selling its assets the recovery is only 150 Cr. Of these 150 Cr, a full 100 Cr will go to fixed income investors while only 50 Cr will go to equity investors. Since investors in fixed income have a much lower risk than investors in stocks, the returns also tend to be lower than those from investments in stocks.
Benefits of Fixed Income Investments:
Diversification: Fixed income assets have a low correlation with stocks. This means that the value of your fixed income investment is unrelated to the performance of the stock market (eg FD bank rates will not fall because the stock market has collapsed); therefore, they ensure the stability of your portfolio by compensating for losses, which may be found in the equity portion of the portfolio.
Less risk: Fixed income investments are generally safer than stocks. First, returns are fixed and non-volatile like returns on stocks, and second, even when an issuer goes bankrupt, fixed income investors have a higher preference than equity investors. This makes such an investment attractive to investors who have a low appetite for risk.
Constant income stream: Fixed income securities generate a steady stream of cash flow for investors. In addition, the amount and timing of these cash flows is also known in advance, which helps investors plan their finances.
Return: Within the fixed income universe, certain assets can offer investors attractive risk-adjusted returns.
Risks associated with fixed income investments:
Credit risk: As noted above, government institutions or private entities can issue fixed income assets. The risk of government default is zero; however, it is not valid for private entities. Thus, investors are exposed to the credit risk of the issuer on securities issued by private entities (banks, companies, etc.). Therefore, understanding the credit profile of the investment is essential before investing in such products.
Interest rate risk: Say an investor, Raju invests in a government bond which gives a 6% coupon for the next ten years and pays the bank principal at the end. Due to changes in macroeconomic conditions (the economy of the whole country), the RBI is increasing pension rates (the rate at which the RBI lends money to banks during the shortage of funds), increasing its rates of interest in force. This government also needs to increase the coupon rate it offers for new borrowing through government bonds – let’s say that coupon rate is 8%. While new investors in the new government bonds would get 8% higher coupons, Raju still receives a 6% lower coupon. This 6% coupon may not be enough to beat the prevailing inflation rates. Let’s say Raju, after holding the bond for a year, wants to sell the same thing (with a remaining nine-year maturity) in the secondary market. Since the new government bonds offer 8% rates, Raju would have to sell his bond at a lower price so that the bond buyer receives 8% interest on his investment. This discount will be reflected approximately by the difference between the new coupon rate and the initial coupon rate multiplied by the residual maturity of the bonds, ie (8% -6%) * 9 = 18%. Thus, Raju would receive around Rs 82 for a main investment of Rs 100 if he chooses to sell his bond.
Some fixed income investments can be:
- Illiquid in nature, i.e. there may not be an active market where investors can sell their investment.
- May have a blocking period before which an investor cannot exit (e.g. your investments in public provident funds – we will discuss this in more detail in our following articles)
- May have penalties for premature withdrawals or exit charges (examples of fixed deposits)
Fixed income investment options
We have discussed what fixed income investing means, its benefits, and the associated risks. Various fixed income investment options available to retail investors are described below in tabular form. These have been classified into two categories
1) Fixed income investments guaranteed by the government, therefore presenting a negligible credit risk.
2) Fixed income investments issued by private entities and subject to credit risk.
by, Ajinkya Kulkarni, co-founder of Wint Wealth