With the recent debacle in Franklin Templeton Debt Schemes and various other Credit Risk funds, would like to highlight some of the prominent risk in Fixed Income Products. Although fixed income products provide stability to one’s asset portfolio, awareness of risk elements in them is of paramount important too.
1. Credit Risk is what one should be vigilant about, this risk occurs when your debt holdings get downward rating from the rating agencies. This can be minimized by refraining from buying securities with negative outlook.
2. Interest rate risk is relevant for investors who invest in Income Funds, the same can be minimised by taking cautious call on the maturity profile of your Mutual fund portfolio or by diversifying with products of different duration.
3. Liquidity risk is where the investment can’t be bought or sold quickly, which can be minimized by investing in highly rated instruments as their marketability is higher, or in Government securities
4. Reinvestment risk is where the reinvested money won’t earn the same return as the original investment, which can be minimized by taking a long call in decreasing interest rate scenario or by investing in Debt Mutual funds
.
5. Inflation risk reduces the value of returns due to inflation, as purchasing power from the returns from your debt funds declines.Investing in a Bank Fixed deposit is a perfect example. Though i don’t deny that they offer absolute safety, but the real returns from these FDs are very low.
5. Inflation risk reduces the value of returns due to inflation, as purchasing power from the returns from your debt funds declines.Investing in a Bank Fixed deposit is a perfect example. Though i don’t deny that they offer absolute safety, but the real returns from these FDs are very low.
6. Default risk is where the promised returns or the principal are not received – Junk bonds have a high default risk while AAA-rated corporate instruments / GOI securities are lesser risky.
Fixed Deposits carries interest rate, inflation and reinvestment risk. Corporate Deposits / NCDs are prone to risks of downgrade and default.
Once we acknowledge that all financial instruments are prone to risk, and also understand each one of them it will be easy to build your Fixed Income portfolio. We can just focus on avoiding risk which we are not comfortable with invest in other instruments.
Happy Investing
RaVi
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