A common financial need for almost all of us is to have a rainy-day fund or a regular income stream or save money for our next generation or any other goal. A common aspect in many of these financial needs is the desire to not lose absolutely any invested or saved capital and grow it at a decent rate (sometimes generate income at a decent rate).
Most of us have used Fixed Bank Deposits, Recurring Bank Deposits and Insurance Savings or Pension schemes to fulfill all our financial needs that have a primary characteristic of not losing a single paisa of the invested / saved capital. An equally important but still a secondary characteristic is to get a “decent” rate of return or interest.
In this blog post we will be trying to discuss safe investments with decent rates of return or interest and whether mutual funds can be a practical alternative to conventional instruments like bank deposits or insurance plans.
Any comparison between investment options needs a good set of qualitative and quantitative metrics, we will be considering Credit Quality, Liquidity, Flexibility, Taxation, Inflation Shield, Volatility, Rate of Return. But before comparing investment options on these metrics let us try to understand some basics of how interest rates work in an economy and how it impacts our financial decisions. According to us, the best way to understand this is to look at the concept of “Yield Curve”
Imagine one of our trustworthy friends approaches us for a business or a personal loan. The most important questions we ask them are:
- How much interest are they going to pay?
- How much time will they take to repay our loan?
The two vital aspects of any money lending / borrowing activity are the rate of interest and the time period taken to return the lent money back.
In today’s date, if the friend seeking for a loan from us offers a 3% per year rate of interest for a period of 3 years (to repay), we would simply deny them the loan as we can get a fixed bank deposit for the same time period at a higher rate of interest (around 5.5%). This particular activity is called benchmarking which is comparing the offer we received with the safest alternative to lend money (bank fixed deposit).
All of us are aware of the golden principle of investing “higher the return desired, higher the risk associated with it or vice versa”. Applying this in the above situation with our friend, the activity of lending them money is absolutely riskier than placing our money in a bank fixed deposit, thus making us desire an interest rate higher than a bank fixed deposit.
Similarly, all of us desire more rate of interest if the same borrower is taking our money for a longer period of time. Just like a three month fixed bank deposit has a lesser interest rate than a three year deposit.
So, in simple words, a yield curve is a graph between time period v/s rate of interest or a graph between credit worthiness v/s rate of interest. Longer the time period, higher the desired rate of interest and lesser the credit worthiness (higher risk), higher the desired rate of interest. In very rare cases, does this equation of yield curve changes (flat or an inverse yield curve).
Bank Fixed (FD) or Recurring Deposits are nothing but a bond between the bank and the depositor where the depositor is lending the bank money with a fixed rate of interest for a fixed period of time that does not change during its lifetime.
An Insurance saving scheme is a basket of investments where the investor is promised a very bare minimum guaranteed rate of return and also some protection against his or her life.
An annuity or a pension is given to the investor by typically an insurance company where a lump sum amount of money is kept with them and the investor receives fixed or variable amounts of pension or income depending on the type of annuity.
A Debt Mutual Fund or a Bond Mutual Fund is a basket of Bonds or Deposits that are actively managed by the fund manager. The bonds in these funds are determined by the type of fund. There are many types of bond funds like Government bond fund, Corporate Bond fund, Banking and PSU Bond Fund, Low Duration (time period) Bond Fund, Liquid Bond Fund, Credit Risk Bond Fund, High yield (Low Credit Quality) Bond Fund etc.
What is a bond?
Coming to the elephant in the room that is a Bond. A Bond or a Debenture is a document between two entities namely a lender and a borrower. Both the entities agree upon a specified amount (face value), rate of interest, frequency of interest payments, time period to return back the borrowed amount and sometimes the purpose or a collateral of borrowing is also mentioned.
Each and every borrower in the economy has a credit worthiness that is measured by credit rating companies in the form of credit ratings. These credit ratings are just like our CIBIL scores. Higher the CIBIL or Credit rating, lower the risk of default.
It’s a common desire to search for a financial instrument that yields a better interest rate than a bank Fixed Deposit but has only very little extra risk in the practical world. This is exactly a high credit quality bond or a debenture. Companies like HDFC Bank that take deposits from account holders also sell bonds in the open market to borrow money for their operations. If this is the case, why is it a bad idea to buy a HDFC bank bond that matures in five years that might yield more than a five-year fixed deposit in HDFC Bank? The risk of losing money is with HDFC Bank collapsing so practically both the Bank Fixed Deposit and the Bond have the same practical risk.
To summarize the idea behind choosing bonds over fixed deposits, one should observe that we can get a better yield for our investment with little or practically no added risk of investing in good and high-quality bonds. The easiest way to achieve this is through debt mutual funds.
What’s the catch?
Just like any other financial instrument, Debt or Bond Mutual Funds have their own risks. Bonds are usually traded on market price so if we need to liquidate them when we need money, we might be getting a lesser market value than our initial investment.
The rate of return for any bond mutual fund is not guaranteed and is driven by market forces. In simpler words, the profits or income we receive from these funds can also be negative based on the market.
With the recent fiascos of Debt or Bond Fund mismanagement by Mutual Fund companies like Franklin Templeton, UTI, Tata and DHFL it has become more vital and critical than ever before to pick the right Mutual Fund for Debt instruments.
Picking a right Investment adviser to avoid such loss of capital in investments that are assumed safe is a very important activity.
Finally, YES Debt or Bond Mutual Funds can be a terrific substitute and a better alternative to conventional Income generation or savings instruments if the right funds are chosen and mapped to investors in a prudent manner.