It is quite easy to see extreme reactions to many aspects of personal money management. Yield-chasing or seeking to invest in high-interest rate fixed income products is no different.
Many investors vehemently believe that there is no place for risk in a portfolio. “We have enough risk from equity, so why take on more risk in fixed income? Debt products should be free from volatility and credit risk” is probably the most popular retail investor sentiment.
This is no doubt the right approach for most investors. Not because of the risk involved in high-yield fixed income but because most investors do not bother to investigate the risks involved.
This is also true of equity investments; many investors are merely riding their luck. In the case of fixed income, the risks are often latent or dormant, like a volcano which can change from a merry tourist site to desolation in a matter of weeks. One day, the product looks nice and rosy, offering higher rates than a “safe bank FD”; another day, you are in despair, fearing loss of principal.
Therefore a combination of “safe fixed income” + “visibly volatile equity” will get the job for all investors, provided they have a goal-based risk management plan to counter the sequence of returns risks.
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That said, it takes all kinds to make the world. We cannot ridicule those who seek higher yields. It is “personal” finance only for those who can personalise it. This means appreciating the pros and cons of our wants/needs and that of the product.
Here are some thumb rules for those who desire higher interest rate products
- You must be mentally prepared to lose the amount invested fully or partially. Unlike equity, where one could “wait” for recovery, money lost usually remains that way.
- Therefore risky debt should form only part of your debt portfolio. Suppose to wish to take risks to the tune of 10% or 20%, then if your portfolio is valued at Rs. 1000 and 60% of it is debt, the risky debt should be no more than Rs. 60 to Rs. 120.
- Whether such a small exposure will make any material difference to your portfolio is something to ponder. If you take on more risk, your health and portfolio will suffer.
- Never chase interest rates after retirement unless you have ample wealth to spare.
- If someone is offering a higher interest rate, they hope to achieve a profit margin on top of this rate. We should stop and think about how easy it is to achieve this. It is, of course, impossible without significant risks.
- Most people forget that we are the lenders in a fixed income instrument. So we need to lend only to those who are financially stable. Therefore yield chasing is similar to stock selection. Just as we would consider the health of a company before buying its equity, we should assess the borrower’s repaying ability, who promises us a high-interest rate.
- There are two kinds of risky debt: concentrated and diversified. Concentrated means you are lending your money to a single borrower. Diversified debt means giving the money to an entity that will lend it to several borrowers.
- Any corporate FD/bond where a firm wanting funds to grow its business offers a fixed deposit or bond is an example of concentrated debt.
- A debt mutual fund or a covered bond is an example of diversified debt. The key difference is that the financial stability of the AMC offering the debt does not (directly) depend on the health of the bonds in the portfolio. The AMC earns money from us for managing the portfolio. If the bonds default, the AMC will not go under.
- In a covered bond, the borrower is refinancing debt from us for loans already incurred on its balance sheet. So if the loans go sour, the borrower’s financial health will degrade, and so will its ability to repay us. Yes, the loans are secured in principle. But how liquid is the security? Most collateral is usually not. So in the event of a default, you will get the money back “sometime”. If many loans in the borrower’s pool default, the borrower will sink too. So there is no protection here against loss or bankruptcy, unlike banks. Remember the Jenga blocks presentation from the “Big Short.” A risk dent can be made to look better by pooling.
- A healthy corporate entity that directly borrows from you (corporate bond or FD) with a strong track record is a better bet than a covered bond. A debt mutual fund that takes a small credit risk is also a reasonable bet for those who desire higher yields.
In summary, for those willing to take the time to appreciate risks and value asset allocation and diversification, there is always a small place for high-interest rate fixed income products in a portfolio. However, the grim reality is that everyone wants a high rate without research. This is why financial influencers thrive! See: Beware of Finance influencers! They can mess up your portfolio! If you don’t have the time or inclination to understand risks, we recommend staying away from risky fixed income.
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