There is nothing fixed in the Fixed Income schemes
A lot has been written on fixed income mutual fund products (a.k.a. debt schemes) and how they can be used as an alternate to fixed deposits for an investor. However, there is something which is paradoxical about fixed income products …it’s the name…unlike fixed deposits where date of maturity and rate of interest is fixed, there is nothing which is fixed for an open ended fixed income product, neither a fixed maturity date and nor a fixed rate of interest (you can read yield).
Counter intuitively, the above facts do not put fixed deposits on a higher pedestal because it is the fixed interest which creates opportunity loss when rates go up as the reset is not available for fixed deposit investors. Similarly, when rates go down there is no mark to market gains available for fixed deposit investors.
The fixed income product can take interest rate risk (identified by the duration of the portfolio) and/or credit risk (identified by the credit quality of the portfolio). The alternate to fixed deposits are products with high credit quality and controlled duration risk and hence the next few lines are written keeping in consideration the interest rate risk only.
Case 1 — A fixed income portfolio is reset at a higher yield when interest rates move up and if held on for a reasonable time this reset helps in recouping the mark to market loss the portfolio would have taken when rates went up.
Case 2 — When interest rates move lower, the portfolios are reset at a lower yield which brings down the potential future income but this is compensated by a mark to market gain the portfolio delivers when rates moved down in the first place.
In the first case, the loss (drop in nav due to marked to market impact) is front ended whereas recovery through higher accrual is back ended. In the second case, the gains (rise in nav due to mark to market impact) are front ended whereas the lower accrual due to lower yield is back ended.
An investor who has a fixed horizon in mind while investing in a fixed income product is vulnerable to interest rate movements and such movements towards end of his investment horizon can swing the holding period returns either way.
If it’s a rate drop, the returns are impacted favourably due to a front ended mark to market gain and if it’s a rate hike, the investor is impacted adversely due to front ended mark to market loss.
Since it’s difficult to predict the interest rate scenario and how they will move in future specially closer to the end of investors investment horizon, the fixed income products (if used as an alternate to fixed deposits) should be considered as an integral and perpetual constituent for overall asset allocation rather than a product with a short to medium term view.
What if there is a defined investment horizon for an investor? The answer is simple, go for a roll down strategy with average maturity of the portfolio in line with the investment horizon. It will protect you from volatility, as portfolio comes close to maturity.
Article by:
Amit Basu — Amit is CEO, Symphonia (a Sapient group company focused on B2B space of mutual fund distribution) and plays an important role in strategy, products, sales & marketing, and training for Sapient Group. He has over 22 years of work experience in the banking and financial services industry. His leisure involvements are poetry and chess.
