Importance Of Fixed Income Diversification

The debt saga that started last year in September 2018 may have a few key lessons for investors. While investing in fixed income instruments, most investors are not aware of the risks inherent in fixed income schemes. Somehow the word “fixed income” invokes the thought in the investors’ mind that by investing in such an instrument/scheme a steady income is more or less guaranteed. This myth was broken during the ongoing turmoil that the debt market is witnessing. Be it banks, mutual funds or investors with fixed deposits in these companies, all are struggling to get the principal back let alone the interest component. Retail investors have also been naïve to think that bank saving deposits are safe. There is no such thing as a “safe” investment. All investments come with a certain degree of risk. One must be cognisant of this risk.

Risk in Fixed Income Basis Maturity

When it comes to equity investments, most investors are aware that diversification is the key to generating optimal returns. It is equally important to diversify your fixed income investments as well. The SEBI fund categorisation may act as good reckoner for investors. The categorisation tends to help in understanding the duration and inherent risk in a particular investment scheme.  For example, a risk-averse investor may look at Overnight Funds or Liquid Funds as the starting point. Overnight funds have instruments maturing the next day. These are the safest investments as the funds primarily invests in the Tri Party Repo (TREPS) maturing the next day. Liquid funds invest in instruments with a maturity of 30 days (this is likely to reduce in the near future). The returns of these funds is commensurate with the investment type that is closer to the risk-free rate. 

Next up on the curve would be ultra-short-term funds with a maturity of 3-6 months and low duration funds with a maturity in the 6-12 months’ period. Investors must note that as the maturity of the fund increases, so does its risk. Money Market funds have an investment horizon of up to a year. The short duration funds have a maturity profile between 1 to 3 years. Medium duration funds have a duration between 3-4 years and medium to long duration funds have the maturity ranging between 4-7 years. The long duration funds have maturity of over 7 years. There are all season funds called dynamic funds where the maturity profile of the fixed income paper is at the discretion of the fund manager. The maturity may vary from 1 day to 30 years or beyond.