Whether it is the blazing sun or the pouring rain, a large expansive tree would definitely provide a degree of shelter. It is human nature to seek shelter when things become a bit too extreme for your liking. Similarly, in the equity markets as well, you would seek shelter when the markets become too volatile or the returns become uncertain in the short-term. Generally, fixed income funds are viewed as the tree under which investors can take shelter from volatile markets. As an investor, you would probably want growth in your portfolio and to achieve this you would inevitably invest in equities. If you are an informed investor, you would also understand the importance of giving your investment portfolio downside protection and hence, would most likely choose to invest in fixed income funds that can potentially give your portfolio some stability as well as ‘fixed income’. But the key question here is, do all fixed income funds provide ‘fixed income’. The short answer to that is ‘no’. The long answer now follows.
Risks in fixed-income securities
It is well-known that the price of a bond is inversely proportional to the prevailing interest rates in the economy. So, if the interest rates in the economy begin to rise, bond prices will fall and if they begin to fall, the bond prices will rise. This change in the price of the bond will result in capital gains or loss. This is the first source of return. The second source of return is, of course, the interest earned on the bond based on the coupon rate of the bond. With this, we can at least establish that fixed income securities are not completely risk free. Some of the risks that you should know:
• Interest rate risk: This is nothing but the way the price of a bond reacts to changes in interest rates. When prevailing interest rates fall, the price of your bond will increase and vice versa. The economic environment and market conditions are the prime factors that affect the interest rates in the market. Further, the longer the duration of a bond's maturity, the more significant the impact of a change in interest rates on its price.
• Inflation risk: Inflation plays a vital role in the interest payment calculation for bond investors. As you know, bonds provide a fixed amount of income at regular intervals. However, as inflation rises, the rate of return on your bond might not match up to the rise in inflation. As a result, you may end up losing purchasing power.
• Credit risk: This is another risk factor that tells us that the income in fixed income is not necessarily fixed. When you invest in fixed income securities it is assumed that you will receive timely interest payments and the return of your principal amount at maturity. However, sometimes, bond issuers are not able to meet their repayment obligations and they default. For example, back in 2017-18, there were several companies in the steel and power sector that defaulted on their bond repayments. The risk of issuer default is called credit risk. Generally, this risk increases with corporates that are not rated very high by credit rating agencies.
• Liquidity risk: This is when you want to sell your fixed income security but cannot find a buyer as you are willing to sell the bond before its maturity. Usually, liquidity risk is higher in the case of bonds with a low credit rating.
• Duration risk: We already know that the price of a bond is inversely proportional to the changes in interest rates. However, not all bond portfolios react the same way to a given change in interest rates. Duration risk measures the specific impact of changes in interest rates to a particular bond portfolio and can have a significant impact on your fixed income returns. When you know the duration of a bond, you can assess the change in the price of a bond with the given change of interest rate.
Make the right choices to reduce risk and enhance returns
It is well known that India has one of the highest road fatalities in the world. Does that mean that you stop driving your car or taking road transport? No! Instead, you learn how to manage the risk. Similarly, even though there are risks in fixed income investing (just as in every other investment), these can be easily managed. What you really need to look at is the modified duration of a bond portfolio and then accordingly make an investment decision. The modified duration will basically tell you how the price of a bond will respond to a given change in interest rates.
Assume the mutual fund portfolio in which you are looking to invest has a modified duration of five years and the interest rate changes by 1.5 percent. Due to the change in the interest rate the price of the bond portfolio will be impacted by 7.5 percent (1.5x5). Generally, higher maturity bonds will have higher modified duration and will thus witness higher volatility due to changes in interest rates. Thus, the time period for which you invest and your ability to absorb volatility is directly related to modified duration.
There are two ways in which you can manage this risk.
• Match your investment horizon with the modified duration of the fund: This one is simple. All you need to do is look at the modified duration of fund in the factsheet and ensure that it matches with your investment time horizon. For example, if you have an investment time horizon of 2 years, then you invest in fund with a modified duration of less than 2 years.
• Invest in target maturity funds: There are certain funds that mature in a specific number of years like 3 years, 5 years or 10 years. To achieve this target maturity, they invest in bonds of the same maturity and simply hold them till they mature. Since the bonds in the portfolio are held till maturity, the interest rate risk is mitigated to a great extent. If you choose to stay invested in a target maturity debt fund till its maturity then you can expect returns similar to what were mentioned at the time you invested in the fund (yield at the time of investment). Even though they would be periodic fluctuations in price, on maturity you will get the expected returns. This way, the impact of interest rates on the value of your investment gets reduced.Fixed income securities can indeed become that umbrella that can protect your portfolio from rain and sun. However, you must be cognisant of the risks and accordingly make the right investment choices.