Liquidity, safety may be hit if you lock in your money in FDs, NCDs, etc, due to current high rates

Bank | admin | October 15, 2011 at 5:38 am

Double-digit returns always fascinate investors. In fact, most people invest in stocks because that is the only way they can earn more than 10%. Not anymore. These days even the humble fixed deposit is giving them almost 10%. Some company deposits and debentures are offering even more. No wonder, everybody is in a hurry to "lock in" their investments at a higher rate, as there is consensus among experts that the interest rates may have almost peaked.

Investors are eschewing stocks because of the depressed stock market and the "fantastic" returns from deposits and bonds.

Who wants to take the risk associated with equities when you can earn 10% in a fixed deposit seems to be the common refrain, say experts. However, in their quest for risk-free double-digit returns, many investors may be slowly walking into a trap, fear experts.

Many investors may be putting all their eggs in debt instruments and compromising on safety and liquidity for higher returns, they say. "Many people invest too much in fixed deposits and NCDs to earn higher returns, adding risk and compromising on safety of capital and liquidity," says Ajay Kinjawadekar, CEO, Moneysafe Financial Services.

Investing too much in fixed income space

"If you are shunning your financial plan and investing in fixed income instruments, you may land in serious trouble, as your portfolio may fall short when it comes to fulfilling your financial goals at the end of the stipulated period," says Amar Pandit, chief executive officer, My Financial Planner.

Consider a simple situation. A financial plan requires an individual to invest 60% in equity and 40% in debt. Equity is expected to earn 15% after taxes, and debt, 7%. If the individual invests as per the financial plan, his/her portfolio would earn around 11.8%. But if he/she decides to invest 40% in equity and 60% in debt, the portfolio returns would fall to 10.2%.

In the long term, as compounding comes into play, the value of the portfolio would differ widely. That is why financial advisors insist on sticking to one's financial plan and ignoring "shortterm" noises. "If you stick to the asset allocation plan and do timely asset rebalancing, you will end up buying low and selling high in an emotionally detached manner," says Amar Pandit.

Ignoring liquidity to earn higher returns

There is a clamour to lock in investments at the best available rate available to cash in on the prevailing higher interest rates.

Naturally, many people would do exactly that. For example, someone would put the money in a fixed maturity plan (FMP) for a longer tenure in the hope of benefiting from the current high rates. But what if the person needs the money before the plan matures? He would be forced to sell his investment at a steep discount on the stock exchange to liquidate his investment.

This is one risk — liquidity risk, in investment parlance — debt investors should be extremely careful about while locking their investments for a particular tenure.

The thumb rule is that you should lock in money in a long-term instrument only if you will not need the money till maturity. Otherwise, make sure you have an exit route that won't cost you much.

"One can lock in money now at attractive yields for the next five years, but if the investment is in a paper rated lower than AAA, then the investor may not realise full profits when yields come down in the next couple of years. This is because he/she may not be able to sell the investment at fair market price due to lack of liquidity," says Joydeep Sen, senior vice-president — advisory desk, fixed income, BNP Paribas Wealth Management. If you are eyeing low-rated instruments, be prepared to face illiquidity on the exchange. If you are buying high-yielding, low-rated NCDs with a view to pocket handsome capital gains as interest rates are expected to come down over the next couple of years, the consider the flip side too.

Compromising on credit quality

'Do you know XYZ company is offering 2% more on deposit than anyone else in the market? Why don't you invest in it?' You may have heard similar recommendation from friends or the so-called experts at some point. Don't fall for such sales pitch. You may regret it later. In your quest to earn 2% extra, you may end up losing your capital. This is because it is mostly low-rated companies that offer higher interest rate to investors.

This is a way to reward investors for the extra risk they are taking. The recent spate of NCD issuances by various NBFCs is a case in point. "Most of these NBFCs cater to clients who otherwise cannot be serviced by banks, given the stringent loan approval process of commercial banks. The higher interest rates offered on NCDs issued by an NBFC are the outcome of the added risks the business carries," explains a fund manager with an Indian mutual fund. That is why it is better to look at the businesses of the issuer before investing in an NCD or company fixed deposits.

"One should look at the rating of the non-convertible debentures and check if they are secured instruments. This information is readily available in the prospectus filed by the issuer," says Deepak Panjwani, head — debt market, GEPL Capital.

"AA-rated papers can be considered by investors as yield levels are attractive now," says Sen of BNP Paribas Wealth Management. Some AA-rated NCDs listed on the exchanges issued by Muthoot Finance and IIISL are quoting at yields of about 14%. But beware of the extra risk you are taking with AA-rated bond. In comparison, the AAA-rated bonds (the highest rating given to bonds) of SBI listed on the exchanges quote at yields of about 9.5%.

Putting all eggs in one basket

One should ideally try and diversify across industries while investing in fixed income instruments.For example, try to invest in fixed deposits of companies from various sectors. Ditto for NCDs, too. "If one invests in papers of companies from one industry, his/her future is married to the fortunes of that industry. In case the industry fortunes turn bad, he/she may lose capital in extreme cases," explains the fund manager.

On the wrong side of interest rates

This is a peculiar scenario in the fixed income space. Interest cycles can always surprise an investor. For example, in early 2008, one could get 9% rate of interest for a 15-month fixed deposit with a bank. In the second half of 2008, the rates dropped to around 6-7%. This was because the RBI had cut policy rates on the back of global credit crisis and most banks responded accordingly. Many investors, who invested in fixed deposits in 2008, had to renew their fixed deposits at lower interest rates during this period.

So, it is very important to take a call on the interest rates before deciding to lock money in different tenures to maximise returns. "Investors should keep a track of fiscal deficit and inflation to have a fair idea of how interest rates will behave in future," says Deepak Panjwani.

For example, most experts believe we are nearing the peak of interest rates. It makes sense to go for longer-term fixed deposits even though the rate of interest payable on them may be merely 25 to 50 basis points lower than the popular one-year fixed deposits. Sure, there is a risk when you are locking in money in long-term instruments, as you may have to compromise on liquidity.

But if your cash flow needs permit, it always makes sense to go for long-term deposit at this juncture.

Source: Economic Times