Why Invest in Fixed-Income Instruments?
Fixed-income instruments in India typically include company bonds, fixed deposits & government schemes.
• Low risk tolerance
One of the key benefits of fixed-income instruments is low risk i.e. the relative safety of principal & 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 & liquidity. Match the investment options with your financial needs.
1. Evaluate credit risk
Credit risk refers to the possibility that the issuer fails to pay what is owed (principal &/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.
Diversification across issuers of fixed-income instruments is a recommended approach to reducing credit risk.
Return calculations should consider effective yield, interest rate expectations & taxes.
1. 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.
2. 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, & vice versa.
3. 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.
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 & penalties of the instrument before you invest.