Safety during Hard Times

The last few years have seen an unprecedented roller-coaster ride in financial markets worldwide. After a significant rally in emerging markets (2003-7) there was a catastrophic decline in global equity and commodity markets in 2008—primarily led by a liquidity squeeze and the hike in interest rates by many central banks. Industry experts predicted that the markets would take several years to recover from the recession and that we were in an extended bear market. However, the global economy saw a spectacular recovery in 2009, with several emerging markets, including India, regaining lost ground.

Investors typically tend to get caught in the herd and overexpose themselves to fancied and possibly over-hyped asset classes. The extremely short cycle of change significantly highlighted the importance of a fixed income allocation in each investor’s portfolio.

It is therefore imperative to streamline asset allocation and give due allotment to fixed income instruments, which provide stability and a steady stream of income to the portfolio. Fixed income investing in India has evolved considerably over the past decade and investors have access to various investment vehicles suited to a variety of requirements.

Apart from common instruments, such as fixed deposits, post office deposits, national savings certificates (NSC), public provident funds (PPF), there are now a variety of other choices. These include debt mutual funds, quasi-sovereign bonds—issued by institutions such as Nabard, IIFCL and REC—with longtenor bonds of up to 10 years offering attractive yields(and in some cases tax-free returns). Finally, there are company bonds and fixed deposits, such as the recent offering of bonds by SBI with rates of around 9.95% for a 15-year deposit.

Fixed-income instruments offer steady returns and provide comfort during times of volatility in other asset classes, such as equities and commodities. For example, over the past three years or so, even though equity markets have delivered negative returns, the fixed income allocation in an investor’s portfolio would have helped them get some returns during the period.

On the flip side, fixed-income instruments don’t have the potential for delivering very high returns. Also several fixed income instruments have penalties for premature withdrawals and, in some cases, only negligible options of premature withdrawals.

Therefore, investors should ladder their investments across various time horizons depending on their liquidity requirements. The allocation to fixed income should be spread out with instruments of different maturities so that investors have liquid cash in hand at almost any point in the near future.

The quantum of debt or fixed income exposure in a portfolio would depend on their risk-tolerance and liquidity requirements. A standard measure to determine the component of debt that needs to be included in one’s portfolio is to take their age as a percentage and invest the same into debt. This means, for a person aged 60; he or she should ideally have 60% in debt and the remaining may go into riskier asset classes. So, the higher the age, the higher the debt component as, in all probability, risk-taking capacity reduces closer to retirement.

However, investors need to invest only after adequately analysing the liquidity and credit-worthiness of the borrower entity and its capacity to repay. In case of mutual funds, investors should understand the underlying portfolio of the schemes invested in to gauge any potential threat. Consult your advisors to determine allocation and choice of instruments.