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Raison d'être of Fixed Income Investments

Investors think that fixed income investments are good when stocks turn bad, but that’s not the way it is

As equity investors’ fear level increases, so does the general interest level in fixed income investments. “Now that equity markets have tanked, should I move my money to fixed income investments?” is a common question that investors ask nowadays. The logic seems so simple. Stocks bad, so FDs good. Except that it doesn’t really work out that way.

There are many good reasons for investing in fixed income. However, the equity markets being down is certainly not one of them. When you do that, then you are essentially saying that the equity markets are going to go lower so your money will be safer in fixed income investments. Essentially, such questions are about predicting the timing of which way the equity markets will move. Timing, for whatever reason, is a bad idea. The likeliest outcome is generally either losses or missed opportunities.

That doesn’t mean that fixed income doesn’t play a role in your portfolio. It does, but for an entirely different set of reasons. There are three possible reasons for investing in fixed income instruments. The biggest is that you are not looking for capital gains. You actually need a stable predictable monthly income from your investments. Generally, this is the kind of need that a retired person has.

The second major reason which calls for fixed income is that you have a defined expense on the short-term or medium-term horizon and you need to make sure that the money budgeted for it stays safe. Perhaps you know you need a couple of lakhs for a child’s education three years from now. Keeping it in a savings account seems pointless since the returns are so low. However, putting the money in equity is way too risky since the actual expenditure can’t be postponed and has the highest priority.

The third set of reason to invest in fixed income is a little more complex, which is asset rebalancing. Asset rebalancing means that instead of seeing the equity-vs-fixed question as a black-vs-white binary choice, you should be seeing it as a shade of grey. Based on the time horizon of your financial needs and your risk tolerance, you could decide to some percentage of your financial investments in equity and some in fixed income. Once every year or so, you could ‘rebalance’ your portfolio. What this means that if the actual balance has veered away from your desired one, you should shift money from one to the other in order to attain that percentage again.

As far as the actual instruments go, the regular income need is probably best met by the post office monthly income plan. These deposits are guaranteed by the government and pay 8.5 per cent a month. You can just calculate the size of the deposit required for the income you need and that’s that. For capital gains, the first choice could be the Senior Citizens Deposit Scheme if the depositor is more than 60 years old. These are also guaranteed by the government and offer a nine per cent rate of return. Nine per cent used to be a real premium rate when this scheme was launched some years back but the scheme is a little less attractive now. I guess if the budget comes before the elections we could finally see a higher interest rate in this scheme.

Of course, there are always bank fixed deposits. These offer interest rates that have generally been quicker in tracking market conditions. As interest rates have risen, most banks are offering close to ten per cent for deposits of over a year. Finally, there are the fixed income mutual funds. These are a complex product and more difficult to choose than the others and are somewhat riskier. On the plus side, one can pull out one’s money at short notice. However, choosing a good income fund is a separate story and we’ll come to that another time.