Investors traditionally seek fixed-income investments. They like the idea of receiving a fixed rate of interest and the safety of the principal invested. The lacklustre performance of equity markets and the persistent increase in interest rates offered on deposits, bonds and debentures has attracted several investors to the debt markets. What, one may ask, are the points to keep in mind while investing in these fixed-income instruments?
First, every investment decision should be backed by the logic of asset allocation. If each product one buys is driven by an expectation of its isolated features, the portfolio as a whole will suffer an excessive focus on selecting the right product and timing the decisions correctly. Both selection and timing are not always correctly implemented, not in the least by simple investors with no expertise or analytical tools on their side. Investors need to ask themselves why they would invest in bank deposits rather than in the equity market. If this choice is driven by their need to derive a regular income and their aversion to the risks in equity markets or their inability to wait for long periods of time before returns become attractive, it is a strategic choice. This asset allocation decision that places their money primarily in bank deposits rather than equity shares is driven by their needs and preferences. Instead, if their decision to buy a debenture rather than an equity fund is based on a view that equity markets will not do well in the near future or that interest rates on bank deposits are likely to fall in the future, the decision is tactical. It is based on a view about what is likely to do better. By definition, strategic allocation decisions endure over time, and tactical allocations require review and modification.
Second, if the decision was indeed tactical, the investor has to be sure when and under what circumstance he would revise the decision. An investor choosing debt over equity at this time would revise the decision if the equity markets were to look up again or if interest rates on debt instruments were to drop. To form this view, investors have to track factors such as global risks, foreign investor inflows, earnings estimates, economic growth and production numbers, investment and consumption data, monetary policy stances, fiscal deficit scenario and credit growth estimates for banks. This is also a partial list. Some of these indicators would lead the change in asset class performance, some would change concurrently and some others would lag. It is commonly known that investors may not venture into such analysis of asset class performance, but may like to change their allocations when they see equity markets going up again. When they are currently investing in debt, with an eye on the equity market’s revival, they need to be sure that their investment enables getting out of debt into equity. The deposits may come with minimum holding periods or penalties for pre-mature encashment or revision in rates for shorter holding periods. Their bonds may not be traded to enable sale or may not fetch a fair price or may have costs and taxes for pre-mature liquidation. It is important to know upfront, how and at what cost a switch back from debt to equity could happen, when desired.
Third, if the investors intend to stay in deposits or bonds, they need to be sure the interest being promised would be paid until maturity. They should look for any clauses for mid-term revision of rates, any call option that would enable the issuer to redeem before maturity or any unilateral alteration in terms that can alter the return from the deposit. It is also important to not overdo the allocation to debt products, trying to “exploit” the high interest rates. A high rate offered by a low-quality issuer may have credit risks that will manifest later. A high interest income, even if safe and offered by a trusted bank, can become inadequate to protect long-term income from rising inflation. Keeping the allocation closely aligned to need and being watchful of hidden clauses in fine print is a caution even the most conservative investor should take.
The writer is managing director, Centre for Investment Education and Learning
