The economic and investment climate is subject to periods of troughs and peaks, which give it volatility and lead to uncertainty about investment returns. For any investor, protecting their portfolio from this inherent volatility while generating returns becomes imperative.
There are several investment instruments that are available in the market. A strong portfolio should ideally have a mix of instruments that can ensure both the safety and the growth of your investment. To achieve the first objective, i.e. security or preservation of capital, investors may consider fixed income investments. This is how it works.
What fixed income investments mean
The very term “fixed income investments” refers to instruments that promise “fixed income” in the form of interest payments. For fixed income investments, the interest payment rate remains fixed or constant throughout the life of the investment, regardless of market fluctuations.
Determining the value of a fixed income investment
The final value or maturity value of a fixed income investment is calculated at the time of its issuance and brought to the attention of the investor, that is to say at the time of the investment. So, as an investor, you know exactly what you will earn at the end of the investment period. This provides the certainty and stability that investors desire when planning to preserve their wealth.
Fixed income investments don’t always give fixed returns
It is important to note that even within the wide range of fixed income investments, not all instruments offer fixed returns. In the case of bonds issued by the government or by specific companies, investors are assured of coupon payments or fixed interest.
On the other hand, there are several other fixed income investments such as debt mutual funds and structured products that do not provide fixed returns and are therefore riskier than regular bonds, but offer higher returns. , especially in a low interest rate environment.
Role of fixed income investments in asset allocation
The key to maximizing risk-adjusted returns is to build a diversified portfolio across multiple assets. By spreading portfolio investments across multiple assets, you can ensure that a sharp drop in the value of an asset class does not have a large impact on portfolio returns. Thus, it helps mitigate risk and maximize risk-adjusted returns.
Things to keep in mind when building your financial portfolio
To create a strong long-term portfolio, you can consider taking the heart-satellite approach. This approach implies that the core of the portfolio should focus on preserving wealth while satellites should focus on growing wealth.
From this perspective, fixed income investments can play a critical role in shaping the core of the portfolio. Since these investments focus on downside protection, stability and liquidity, they can make the core of the portfolio robust and strong enough to withstand volatile investment environments.
However, it is important to note that these investments serve better to protect the portfolio than to maximize the return. Thus, the portfolio’s satellites can invest in equities and alternative investments to maximize the potential return of the portfolio.
By following this approach, investors can meet the dual objective of preserving wealth and growing. In addition, due to the inherent stability these investments offer, they are well suited to investors who are risk averse or have a low risk threshold.
Benefits of Fixed Income Investments
Depending on the financial goals, risk profile and investment schedule of investors, fixed income investments can offer potential benefits. Some of them include:
Diversification of stock market risk
It is generally assumed that fixed income investments are relatively safer or less risky than equity investments. This advantage stems from their ability to offer fixed returns even in changing macro and microeconomic environments.
For an investor looking to generate attractive returns over the long term, an equity orientation would be a viable choice. However, this bias also increases the risk in the portfolio. Thus, by allocating a certain proportion of the portfolio to fixed income investments, investors can potentially offset losses suffered during stock market downturns, thereby mitigating the overall risk of the portfolio.
Preservation of capital
Preservation of capital consists of protecting the absolute value of the amount invested. Preservation of capital can only be achieved by investing in certain instruments such as specific fixed income options.
Since these investments carry relatively less risk than stocks and offer a fixed return over a period of time, they can offer investors the desired preservation of capital. However, investors should be aware of the risk of inflation, i.e. investments lose value over time due to a general increase in prices.
Due to their low risk nature, most fixed income investments do not offer very high returns. However, what they offer is a stable source of income. Investors either receive a fixed amount of income at regular intervals in the form of interest payments on their holding, or a cumulative amount comprising the principal plus the total interest received at the end of the holding period.
Some fixed income investments can also potentially offer attractive returns. However, it’s important to remember that these fixed income investments involve higher levels of risk and may not offer the same types of downside protection that vanilla fixed income investments do.
Risks to keep in mind when investing in fixed income investments
There are four major risks associated with fixed income securities. These include:
Interest rate risk
Bond prices have an inverse relationship with interest. When interest rates rise, the price of a bond falls. This means that the value of the fixed income investment in your portfolio will decrease with an increase in interest rates. This could cause some volatility in your portfolio.
Inflation refers to the general increase in prices and the impact on an individual’s purchasing power. One of the main advantages of fixed income investments is that they offer a fixed rate of return. However, if the rate of return is lower than the rate of price increase i.e. inflation, the investor will lose purchasing power. But this condition is rare in a stable economy.
Plain vanilla fixed income investments offer a fixed rate of return that is generally lower than the return offered by many investments. However, investors can improve their bond yields by taking higher levels of risk and investing in corporate bonds. These bonds may offer higher yields but are also relatively riskier.
The higher risk arises from the possibility that the issuing company could default on its obligation due to which investors may not receive the full value of the invested capital. This is the credit risk.
This is the inability of bondholders to easily sell the fixed income investment at fair value. These risks can be cleverly managed by spreading the portfolio over several types of fixed income investments.
Fixed income investment options
Within the fixed income asset class, investors have the opportunity to invest in a wide range of instruments that offer different levels of return and are located at different points of the risk spectrum.
Investors looking for guaranteed returns may want to consider investing in the following areas:
- Public provident fund (PPF)
- Bank term deposits (FD)
- Government-issued bonds
- National Savings Certificates (NSC)
- Debt mutual funds
For more sophisticated investors looking for higher risk-adjusted returns, there are various options like the following:
- Corporate FD
- Non-convertible debentures (NCDs)
- Structured debt products
These can potentially generate a higher return in a low interest rate environment with a slightly higher level of risk.
Tax treatment of fixed income investments
The tax treatment of fixed income investments depends on the type of investment. Some points to note include:
- Certain investments like those made in PPFs, NSCs, 5-year bank deposits, etc. may be claimed as a tax deduction under Section 80C of the Income Tax Act.
- Gains realized on investment in debt mutual funds are divided into short-term capital gains, that is, gains made on an investment redeemed within three years of the date of grant or grant. purchase and long-term capital gains, that is, gains made on investments redeemed after a period of three years. Short-term capital gains tax (STCG) is the applicable tax rate of the investor. Long-term capital gains tax (LTCG) is 20% with indexation benefits.
- The taxation of bond investments will vary depending on the length of ownership and whether they are listed or unlisted. To better understand the tax implications of fixed income investments, it would be advisable to consult your advisor.
- In the case of non-taxable bonds, interest earned on these bonds is exempt from tax. However, capital gains resulting from the sale of tax-free bonds are still taxed in accordance with the above guidelines.
Investors can cope with the constantly changing investment environment by diversifying their investments across multiple asset classes. Some asset classes, such as fixed income investments, offer fixed returns and are relatively safe. These investments provide the investor with the necessary stability and visibility into future returns.
On the other hand, equity investments have the potential to generate attractive returns over the long term. However, these investments are associated with higher levels of risk. The composition of these asset classes in the portfolio will depend on the investor’s risk profile, return requirements and the investment schedule.
It is important to remember that only a stable portfolio with a solid foundation will be able to generate long term returns. From this perspective, fixed income investments play an important role in building a strong portfolio.