The Mysteries of Fixed Income
Updated: Jan 17, 2022
A few years ago if you invested in fixed income (debt) funds, there was no question that you'd not get 8%. It was a no brainer. You'd be labeled as a conspiracy theorist if you questioned credit ratings or worried about defaults, liquidity, etc. Debt was a reliable friend that gave you the bliss of stable returns. Fast forward to 2020 and you can't say the words 'debt' or 'fixed income' without raising a few suspicious eyebrows. What began with IL&FS as an isolated incident in September 2018 turned into a full blown crisis that affected almost every portfolio. Then followed Yes Bank, DHFL, PMC, Franklin, and more. What went wrong? Were we in dreamland earlier and inevitably woke up to a harsh reality?
By now it's pretty clear that debt is not the simpleton we all thought it was; it's a far more nuanced asset class. And let's face it, our understanding of the asset class was hopelessly non-existent. The risks that have just come to light were always there. We were just oblivious to them. This piece intends to dive into debt and understand its risks, rewards, and purpose in the portfolio. Adversity is a good teacher and as investors, it's in our best interest to understand this asset class better!
Debt and its Purpose in the Portfolio
Debt means giving out a loan to someone for a fixed interest payment, usually with a maturity period. When you do an FD, you're loaning to the bank. PPF is a loan to the govt. As the name suggests, 'fixed income' or debt is supposed to be a predictable and consistent source of revenue to the portfolio. It is by nature a defensive asset class i.e. there is a cap on the return you can generate (the rate of interest you've fixed). Therefore, it makes little intuitive sense to take excessive risk in debt. It is optimally designed to play the following roles in the portfolio.
Capital preservation (stability) - Creates a strong foundation
Store of Liquidity - For emergency needs & short term objectives
Provides Diversification from Growth Assets (store of value) - Your debt portfolio should NOT behave like stocks i.e. volatile.
Ask yourself - Is your debt portfolio truly constructed to fulfill its intended role?
The Risks of Investing in Fixed Income
1. Credit Risk - This is the risk of default i.e. the person you've lent to fails to pay the principal and/or interest in part or full. It is currently responsible for plaguing India's debt markets with fear. And rightly so. Credit risk can be binary. The best case scenario is the rate of interest and the worst case scenario is every penny you've lent disappears (0 or 1). Seems like skewed risk reward ratio to me. This is the reason taking excessive credit risk is foolish. How to avoid/mitigate credit risk - One way is to invest in highly rated entities. Unfortunately, credit rating agencies in India have been a tad bit mischievous…I mean unreliable. Remember what IL&FS, DHFL, and Yes Bank's rating before they defaulted? The best way to manage credit risk (in addition to looking at rating agencies) is to make sure you spread your money across several borrowers. Lending Rs. 100 to one borrower is far riskier than lending Rs. 1 to a hundred people. Another solid way to protect yourself is to check for collateral. Do you have some security in the event of a default?
2. Interest Rate Risk - Imagine you invest Rs. 100 in a government bond that gives you 6%. Six months later, the RBI increases interest rates and the govt. issues new bonds at 7%. You want 7% too, so you try to sell the one you have to buy the new ones. Unfortunately, nobody is interested in buying a bond that gives only 6% anymore and so you have to sell it at a loss - at Rs. 95. This is interest rate risk; the change in price of a debt security for a change in the interest rate. How to avoid/mitigate interest rate risk - while there are several methods to mitigate risk, avoidance is probably the best strategy. Interest rate risk is measured by a term called 'modified duration'. Generally, longer duration (time to maturity) = higher modified duration = higherer interest rate risk. Modified Duration is a commonly published metric that's easily available on almost all business sites.
3. Inflation Risk - Silent and deadly! Post tax, fixed income struggles to keep up with inflation (usually trails behind). When an investment offers a lower return than inflation, technically wealth is being destroyed. To convincingly beat inflation, fixed income usually has to take an excess of one or both of the above risks. How to avoid/mitigate inflation risk - Asset allocation! Diversify your portfolio between growth (e.g. equity) and defensive asset classes.
4. Reinvestment Risk - Let's say you've invested in security that pays a coupon (interest) of 8% every year. You'd like you reinvest the cash at the same rate (i.e. 8%). Unfortunately, you're unable to find a suitable borrower or the interest rates have now dropped. Ergo, you've lost out on potential compounding. 8% compounded on Rs. 100 for ten years gives Rs. 216. Simple interest gives you Rs. 180. This difference is reinvestment risk. For those who are oblivious to it, it can put a large dent in the portfolio over time. How to avoid/mitigate reinvestment risk - The best way is to invest in debt securities that don't give a frequent payout. One example is zero coupon bonds. Another way is to invest in professionally managed debt funds, where fund managers are cognizant of this risk and proactively manage it.
How do I Pick out a Product?
The number of fixed income products in the market are endless. Popular ones are FDs, PPF, Govt/PSU/RBI Bonds, insurance (e.g. endowment plans), debt mutual funds, corporate/NBFCs debentures, etc. A Bond/debenture is a name given to the security that contains details such as rate of interest, maturity date, details of collateral, and other relevant details. The borrower issues the bond/debenture and the lender becomes the its owner. It is like a contract between the two parties.
Some products are easy to understand (e.g. an FD). Others can be quite complicated in their structure. However, irrespective of how complex the product may seem, the essence remain the same i.e. you're lending a certain sum to another party(ies). The risks remain the same. We'd recommend you approach every fixed income product with a view to unravel the above risks. You'll find that understanding the product becomes much easier.