When we were school kids we used to lend and borrow pencil, eraser etc.. This practice of loan which started in our school days continued as borrowing milk and coffee powder which later developed as Housing Loan and Bank deposits.
Institutions receive money from us in two ways. In the first category we buy shares giving our money and become shareholders. If the company earns profit, we may get interest. The prices of shares will fluctuate, as we have seen. As there is no fixed income for our investment and the price of shares fluctuate, a lot of people never enter this zone. What do they do with the money they earn?
Depending on our income, we can lend money to companies in another method. We can finalize the rate of interest and lend money to companies/banks. This is the investment based on debt instruments. Some people may think, "Bank is for getting loans only, what is this new story?" The deposits we make in banks are equal to loans we give to banks. Giving money to individuals, banks or even government and receiving interest from them is an investment based on loan.
This path of investment is also not a four lane trunk road strewn with roses. There may be thorns and rough stones. If we travel with care, it is worry free investment. Let us see how to remove the thorns in our path.
FIRST THORN TO BE REMOVED - CREDIT RISK
The repayment capacity for paying interest and the principal is called ‘Credit risk’. There is a measuring scale for this. The symbols for credit risk are “AAA, AA+, AA- and A. “AAA” means the least risk. Single A means heavy risk. This symbol is given for debentures, and fixed deposits. The institutions which examine the individual companies and allot these symbols for Credit risk are “CRISIL, CARE and ICRA”. Principal and interest will be returned by government without any doubt and so it is called “Sovereign”. So credit risk should be understood and loan may be given where the risk is less.
NEXT THORN – CHANGES IN INTEREST RATES
Some people may remember that before 20 to 30 years bank deposits earned 14% to 13% interest. Now getting 7% to 8% is very difficult. The interest rates may slightly differ from institution to institution. If the credit risk is less, the interest rate we receive will also be less. In a AAA rated company the interest rate will be less. The interest rate of ‘A’ rated concern will be slightly higher. This will change from country to country. The Bank deposit interest rate in India is about 7% to 8%. But in America the bank deposit interest rate is from 0.25% to 1% only. This is because the central banks of the nations maintain their financial position by reducing or increasing the interest rate see Figure-1. Our Reserve Bank of India has reduced the interest rate in the last year. It is expected that the rate may be reduced further. The impact makes the depositors of bank fixed deposits to do receive less interest. But the borrowers who availed housing loans have to pay lesser interest. At the same time, instead of bank fixed deposits, if money is invested in Mutual Funds, even if the RBI rate of interest is reduced, the depositor will earn more interest.
We found out about the thorns in debt instruments. Now let us see how many paths are there.. Which path has lesser thorns? Where there are no thorns at all? We can verify and select.
Here are some of the paths:
1. Individual Loans.
2. All types of Bank Deposits including Fixed Deposits, Monthly Recurring deposits.
3. All types of Deposits in Financial Institutions.
4. All types of deposits in Post Offices Fixed, Monthly, etc.
5. Public Provident Fund.
6. Government Bonds.
Please see Table – 1
Now you would have understood the risks and returns. The Risk Vs Returns will apply to Debt Instruments like shares. If we manage the thorns of risks we can get some more income above the Bank deposits in Mutual Funds on Debt related instruments. Please see Figure 2 . Tax payers can earn around 2.87%
if they invest in Mutual Funds on Debt instruments instead of Bank deposits. This analysis is arrived by comparing the yields of Reliance Regular Savings Funds Vs Bank deposits.
Finally we can see that Investments based on Debt instruments have less fluctuations and fixed interest rate is available. If we invest in Mutual Funds base on Debt Instruments we can get more gains than investing in Bank deposits.
Institutions receive money from us in two ways. In the first category we buy shares giving our money and become shareholders. If the company earns profit, we may get interest. The prices of shares will fluctuate, as we have seen. As there is no fixed income for our investment and the price of shares fluctuate, a lot of people never enter this zone. What do they do with the money they earn?
Depending on our income, we can lend money to companies in another method. We can finalize the rate of interest and lend money to companies/banks. This is the investment based on debt instruments. Some people may think, "Bank is for getting loans only, what is this new story?" The deposits we make in banks are equal to loans we give to banks. Giving money to individuals, banks or even government and receiving interest from them is an investment based on loan.
This path of investment is also not a four lane trunk road strewn with roses. There may be thorns and rough stones. If we travel with care, it is worry free investment. Let us see how to remove the thorns in our path.
FIRST THORN TO BE REMOVED - CREDIT RISK
The repayment capacity for paying interest and the principal is called ‘Credit risk’. There is a measuring scale for this. The symbols for credit risk are “AAA, AA+, AA- and A. “AAA” means the least risk. Single A means heavy risk. This symbol is given for debentures, and fixed deposits. The institutions which examine the individual companies and allot these symbols for Credit risk are “CRISIL, CARE and ICRA”. Principal and interest will be returned by government without any doubt and so it is called “Sovereign”. So credit risk should be understood and loan may be given where the risk is less.
NEXT THORN – CHANGES IN INTEREST RATES
Some people may remember that before 20 to 30 years bank deposits earned 14% to 13% interest. Now getting 7% to 8% is very difficult. The interest rates may slightly differ from institution to institution. If the credit risk is less, the interest rate we receive will also be less. In a AAA rated company the interest rate will be less. The interest rate of ‘A’ rated concern will be slightly higher. This will change from country to country. The Bank deposit interest rate in India is about 7% to 8%. But in America the bank deposit interest rate is from 0.25% to 1% only. This is because the central banks of the nations maintain their financial position by reducing or increasing the interest rate see Figure-1. Our Reserve Bank of India has reduced the interest rate in the last year. It is expected that the rate may be reduced further. The impact makes the depositors of bank fixed deposits to do receive less interest. But the borrowers who availed housing loans have to pay lesser interest. At the same time, instead of bank fixed deposits, if money is invested in Mutual Funds, even if the RBI rate of interest is reduced, the depositor will earn more interest.
We found out about the thorns in debt instruments. Now let us see how many paths are there.. Which path has lesser thorns? Where there are no thorns at all? We can verify and select.
Here are some of the paths:
1. Individual Loans.
2. All types of Bank Deposits including Fixed Deposits, Monthly Recurring deposits.
3. All types of Deposits in Financial Institutions.
4. All types of deposits in Post Offices Fixed, Monthly, etc.
5. Public Provident Fund.
6. Government Bonds.
Please see Table – 1
Types of Debt Instruments
|
Credit Risk
|
Interest Rate Risk
|
Remarks
|
Personal Loans given to individuals by individuals
|
High
|
Low
|
Return is Usually high - credit risk
varies from person to person depending upon their repayment capacity
and intent
|
All type of Bank deposits
|
Low
|
Low
|
Interest rate is mostly fixed - varies from bank to bank
|
Deposits with corporates
|
High
|
Low
|
Return is usually high than the bank deposits - mostly fixed interest rate - varies with corporates
based on their ratings
|
All type of Post office deposits
|
Sovereign
|
low
|
Moderate
|
PPF
|
Sovereign
|
Average
|
Rates changes every quarter
|
Government Bonds
|
Sovereign
|
high
|
when we buy this bond in market, yield will change based on our
purchase price
|
Now you would have understood the risks and returns. The Risk Vs Returns will apply to Debt Instruments like shares. If we manage the thorns of risks we can get some more income above the Bank deposits in Mutual Funds on Debt related instruments. Please see Figure 2 . Tax payers can earn around 2.87%
if they invest in Mutual Funds on Debt instruments instead of Bank deposits. This analysis is arrived by comparing the yields of Reliance Regular Savings Funds Vs Bank deposits.
Finally we can see that Investments based on Debt instruments have less fluctuations and fixed interest rate is available. If we invest in Mutual Funds base on Debt Instruments we can get more gains than investing in Bank deposits.
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