BENEFITS OF FIXED INCOME INTRUMENTS

Fixed-income instruments in India typically include company bonds, fixed deposits and government schemes



Low risk tolerance :

One of the key benefits of fixed-income instruments is low risk i.e. the relative safety of principal and a predictable rate of return (yield). If your risk tolerance level is low, fixed-income investments might suit your investment needs better.

Need for returns in the short-term :

Investment in equity shares is recommended only for that portion of your wealth for which you are unlikely to have a need in the short-term, at least five-years. Consequently, the money that you are likely to need in the short-term (for capital or other expenses), should be invested in fixed-income instruments.

Predictable versus Uncertain Returns :

Returns from fixed-income instruments are predictable i.e. they offer a fixed rate of return. In comparison, returns from shares are uncertain. If you need a certain predictable stream of income, fixed-income instruments are recommended.

HOW TO INVEST IN FIXED INCOME?


Before you decide to invest in fixed-income instruments, evaluate your needs from three key perspectives - risk, returns and liquidity. Match the investment options with your financial needs.


RISK
  • Evaluate credit risk :
  • Credit risk refers to the possibility that the issuer fails to pay what is owed (principal and/or interest). Evaluate the credit ratings assigned by rating agencies to find corporate bonds/ fixed deposits that match your risk tolerance level. Please note that it is not mandatory for non-finance companies to get a credit rating for their fixed deposit schemes. Hence, it is advisable to see if the company has a credit rating for any other debt instrument while evaluating fixed deposit schemes.


  • Evaluate credit risk :
  • Diversification across issuers of fixed-income instruments is a recommended approach to reducing credit risk.

RETURNS

Return calculations should consider effective yield, interest rate expectations and taxes.

  • Calculate effective yield :
  • Calculate the post-tax effective yield for each instrument for comparison. Effective yield is the IRR (Internal Rate of Return) of the fixed-income instrument.

  • Consider interest rate (and inflation) expectations :
  • Once you invest in a fixed-income instrument, your investment is committed, more often than not, for the specified period of time. During this period, if interest rates increase, you will not benefit from this rise. Hence your effective return from this investment will be lower than if you had the flexibility to invest at a higher interest rate. So, if you expect interest rates to increase, invest only in short-term instruments, and vice versa.

  • Don’t forget taxes :
  • While calculating your interest yield remember to include post-tax interest receipts. For investors in high-tax brackets, tax-free government bonds/ schemes might be more attractive.

LIQUIDITY

Fixed-income instruments are normally illiquid as the secondary market for these instruments is not yet developed in India. Make sure you carefully evaluate the potential liquidity, exit route and penalties of the instrument before you invest.

WHERE TO INVEST?

Company Fixed Deposits

Fixed Deposits in companies that earn a fixed rate of return over a period of time are called Company Fixed Deposits. Financial institutions, Non-Banking Finance Companies (NBFCs) and Manufacturing companies also accept such deposits. Deposits thus mobilized are governed by the Companies Act under Section 58A. These deposits are unsecured, i.e., if the company defaults, the investor cannot sell the documents to recover his capital, thus making them a risky investment option. Company Fixed Deposits are adequate for regular income with the option to receive monthly, quarterly, half-yearly, and annual interest income. Company FDs can be an interesting investment option if you know how to select the right FD, and how to avoid the not so good ones. Here are some of the points that investors should keep in mind

Spread your Risk:

The deposits should be spread over a large number of companies engaged in different industries. By this way, you will be able to diversify your risk among various industries/companies. Try not to put more than 10% of your total investments in one particular company.

Periodic Review :

The performance of the companies should be reviewed at maturity. This will help you decide whether to renew or reshuffle the deposit. It is also wise to keep a track of these companies by checking their share prices, balance sheets, annual reports, etc.