Bond defaults and even Mutual Funds have hurt investors
In the last 2 years, investors (many of them individuals) have lost money by investing in bonds that have defaulted and failed to repay the principal amount invested. Bonds issued by IL&FS. DHFL, Reliance Capital, Yes Bank and other issuers have defaulted. Investors invested in fixed income mutual fund schemes of Franklin Templeton, BOI AXA have lost significant money as these schemes had invested in bonds that defaulted.
Investors in fixed income products look for steady and safe returns and when they lose money in their fixed income investments, their savings take a beating. This brings us to the question, why investors took extra risks in investing in bonds and fixed income schemes that defaulted or lost them significant money.
How to earn returns that beat inflation?
Given that earnings from interest rate products are lower than inflation, the question constantly asked is how to earn returns that are higher than inflation. This involves risk that many investors may not have the appetite. Investing in longer maturity bonds or in bonds of issuers where credit risk is high is not a good option for low risk investors. Equities may be too volatile and real estate is too expensive and illiquid. Gold prices are at record highs and from here risk may be higher.
There is no safe and sure way to beat inflation but a good bond strategy will help.
Why investors take extra risks in some bonds?
The reason investors take extra risks in bonds is the promise of higher interest rates they offer. Many investors believed that bonds and fixed income schemes would not hurt them as they were fixed income instruments and when they lost money on defaults they did not know where to go.
To be fair, bonds such as IL&FS, DHFL, Reliance Capital and Yes Bank were all at one point of time rated AAA, which is the highest safety rating that signifies highest safety of principal. Nobody ever imagined that such bonds will default and yet they defaulted. Given this unnerving experience, should you invest in bonds at all and just keep the money safe in fixed deposits of PSU banks that yield almost nothing now.
Invest in bonds and avoid potential bond defaults by choosing the right bonds
Bonds can offer higher yields than fixed deposits and also believe it or not provide capital gains. Hence it must be looked at as a very good alternative to fixed deposits. However to get the best out of bond investments you need to ask yourselves 3 most important questions.
- Will interest rates move up or down in the future?
- What will guarantee my principle repayment?
- Can I sell the bond if I see a threat to my investment?
These 3 questions will have to be answered by your bond advisor or by you if possible. We will look at these question individually in the next issue of Search for Yields.