In the early 90s, that is about 30 years back, only a few thousands of middle class Indians owned a car. Owning a house was a privilege of a handful as home financing options were limited and saving for a house took decades. It was a slow-paced life, with India growing at just 4-5%. But people’s fixed income investments were growing at great rates. There were several ‘safe’ investments that gave returns of over 10%, back then.
Take for instance, the National Savings Certificate (NSC) offered 12% per annum. Even bank deposits were in the range of 9-13% in the late 90s according to the Reserve Bank of India website. Even before the deregulation of term deposits in 1996, the ceiling on the deposit rate was around 13%.
Even if one looked at inflation adjusted returns then, it was high. This is because inflation was much less. According to a study done by Bornali Bhandari, Fellow, NCAER and Rumki Majumdar, Senior Analyst, Infosys, the period between 1994-95 and 2004-05 saw a consistent decline in inflation. The data from the Indian Ministry of Labor corroborates this. It shows that consumer inflation was below 5% from the late 90s to early 2005. Hence, the middle class then, could make considerable money by investing in fixed income paper that gave a real return of over 5-7%. The share market was also a money spinner.
But things have changed a lot since then. India started growing at 7-9%. Even though inflation has moderated, bank fixed deposit rates have fallen below 8%. This led to negative real returns for the conservative investor. Taxes make the situation even worse. Your deposits, NSC, bonds and debentures are all taxable. So, this defies the first myth about fixed income investments.
#Myth No.1 – One can create wealth using only fixed income investments
The average return from traditional fixed income security ranges anywhere between 7% and 9% per annum, over a five-year period. But the share market still rocks. If one takes the performance of mutual funds, the average returns of best mutual funds are anywhere between 10% and 15%, over the same period.
With inflation averaging at over 6% and high tax rates, it is impossible for those who have invested in only traditional investments to create any wealth in the long run. If you invest only in fixed income securities, you could be depleting your assets in real value while maintaining it in absolute terms. So, it is prudent to invest in either equity or equity linked investments, real estate or gold for creating wealth.
#Myth No.2 – Fixed income investments are risk free
Nothing in this world is risk free and fixed income investments are no exception. Any investment that you make today carries some amount of risk. When you invest in a fixed deposit, you face reinvestment risk. This is the risk that you might not get the same interest rate when the deposit matures. Another risk is inflation risk. This is the risk that the returns from your fixed deposit won’t beat inflation. There is the risk of default when you invest in company deposits. You might face liquidity risk too if you can’t prematurely withdraw your deposit.
Apart from this, you have the interest rate risk where changes in interest rates could adversely impact your return from a fixed income security. Even Public Provident Fund entails interest rate risks as the PPF rate is now benchmarked to Government security rate.
#Myth No.3 – Your age = % to be invested in fixed income investments
Generally, financial advisers tell you to base your asset allocation on your age. This means that if you are 30 years old, you would need to allocate 30 per cent of your portfolio to fixed income investments. This is not the best approach. Mainly because asset allocation should be based on your goals and the age-based allocation doesn’t take into account your goals, risk profile or financial position.
The allocation to fixed income in an investment portfolio should be tied to one’s risk appetite as well as cash flow needs captured in the goals. It is ideal to pick instruments that match the tenure of your goal so that they mature when it is time to reach your goal.
In case your goal is a long-term one, you can choose slightly riskier investments. Equity mutual funds are a good example. These mutual funds of over one year give good tax adjusted returns and can be aligned to your long-term goals. If the instrument tenure is shorter than the goal, try rolling over the investment as and when it matures.
Just like you work to build an equity portfolio by selecting the right stocks and mutual funds, you need to pick the right fixed income investments for a well-diversified portfolio. Here’s how you should build your portfolio to ensure that it is aligned to your goals.
1. Determine your goals
2. Calculate the amount to be invested for each goal (based on cash flow required and risk profile)
3. Choose instruments (based on goal tenure, cash flow and risk profile)
4. Ensure that your portfolio is diversified and is not totally illiquid
5. Review the portfolio at least once a year
6. Re-balance when interest rates change drastically or credit risk goes up
A meal is never complete without starters and desserts. Similarly, a portfolio cannot be complete or effective unless it consists of equities and debt instruments. You need to strike the right balance between equity and debt for financial satisfaction and successful achievement of goals. If you think you don’t know much about asset allocation, get the help of a financial planner. Proper asset allocation and diversified investments will help you minimise risks while maximising returns.
Want to know more? Read this article – The Importance Of Diversifying Your Investments And Asset Allocation.