Our fixed income investments largely hovers around FDs, RDs and small savings schemes. We 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 fixed income avenues. Due to this many of us completely avoid debt products with variable income. But with small savings schemes being made market linked, investors looking for fixed income options will have to consider alternatives.
For long term investments fixed income products with variable income have to yet see a share in the investors portfolio. Although, in last few years products like NCDs, FMPs etc. have seen a huge attraction, it has been more for higher returns offered by these instruments. 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.
Following are the type of risk present in fixed income products which has to be taken in consideration while investing –
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 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 you 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 you if you wish 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 you 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 you earns from them. Since it’s difficult for most of us 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 article is authored by me and first appeared at moneycontrol.com
Are you aware of these risks?How you create your fixed income portfolio?
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