Fixed income instruments: Are you playing a losing game?

January 21, 2018 0 Ankit Shrivastav

Introduction:

Fixed income instruments (fixed deposits, corporate and government bonds etc) have always been a popular investment option for investors looking to grow their investment safely. Fixed income instruments pay a fixed percentage of interest on the principal periodically.

The reason why these instruments are so popular is that they are safer compared to other investment options such as stocks, commodities and real estate, where there is no certainty of the return on investments and prices are highly volatile.

Also, most of the fixed income instruments are rated for their safety by many rating agencies, that assess the riskiness of an asset and provide a rating depending on the likeliness of return on invested capital.

should you invest in fixed income instrumentsIf fixed income instruments are so good, why is it a losing game for an investor? There are many reasons behind why investing in a fixed income instrument is a game you are bound to lose.

First, I mentioned earlier that fixed income instruments are relatively safer compared to other asset classes such as stocks, commodities and real estate, and thus are preferred by conservative investors. However, safety does not mean certainty. No matter how high the rating of a bond is, there is always a chance of default.

An example of it was recently witnessed by the world during the 2008-09 subprime lending crisis where even highest AAA rated bonds defaulted on their payments, leading to a financial meltdown, pushing the world economy into recession.

The downside of investing in fixed income instruments are not limited to default on payments. There are many reasons why fixed income instruments are not a great way to invest your money, especially for long term.

If you look at the history of these instruments, both in the domestic market as well as globally, you will find that investing in fixed income instruments is a game you are certain to lose especially in the long term. To understand it in a better way, let us look at it as how it impacts you as an individual and the world economy.

How does it affect you?

There are two big reasons why fixed income instrument are not a good asset class to invest.

Fixed income instruments are usually taxed:

Barring few instruments, (such as National Savings Certificate, which provides tax exemption under Section 80C) interest earned on most of the fixed income instruments is taxed as per your tax slab.

Your income from salary and investment is added up to determine the tax slab that you fall into and tax will be applied as per the slab. The tax slab for the year 2017-18 is given below:

For example, if your total income from your salary or profession and other sources is Rs. 10 lacs per annum, then you will have to pay 20% of your income as tax.

These taxes can take a big portion out of your interest income, and you get to pocket a small portion of the interest earned. On the other hand, profit earned from investing in stocks are exempt from taxes, if the stock is held for more than one year.

High inflation can also swallow your interest income:

The prosperity of any economy depends on the net disposable income which is a difference between per capita income and expenditure of the country’s citizen. But this prosperity comes at a cost. Higher disposable income leads to higher consumption, and since resources on our earth are limited, a lot of money chases limited amount of goods and services.

This leads to rising prices of goods which is called inflation. Inflation is represented in percentage terms, which indicates percentage price rise in goods and services compared to previous year.

For Example, inflation of 10% means the price of goods and services is increasing 10% every year. To counter the effect of inflation we invest our surplus money in order to maintain its purchasing power.

While little inflation is good for the prosperity of the economy, high rate of inflation can have a negative impact,?as people have to earn more money in order to maintain their current lifestyle. Inflation not only impacts your lifestyle but also deprives you of future prosperity. To understand this in a better way let us take an example:

Example:

Let us say you have invested your hard earned money in a fixed deposit which earns 10% interest on the principal. Let us also assume that current inflation rate is at 3% per annum. Assuming there are no taxes, the return you will get on your investment after adjusting for inflation is 7% (10%-3%=7%).

Now since your return is fixed, in case there is a rise in the inflation rate, you will get lower return on investment. If inflation rate rises from 3% to 6%, the inflation-adjusted return would be 4% (10%-6% =4%). As it is evident from the example above, high inflation can deprive you of future financial prosperity.

Return on stock market investment are variable, and if we look at more than 100 year old history of stock market, it has provided highest return on investment in comparison to other asset classes. While inflation still hurts stock market returns, the overall impact is minimized by because of high returns.

They do not take advantage of high economic growth:

The third and the biggest disadvantage of the fixed income instruments is that they do not take advantage of of high economic growth of a country. When an underdeveloped economy starts to growing, the economic growth rate is usually very high.

Stock market, being directly related to economic growth of the country, participate in the economic growth, and provide investors high return on their invested capital.

On the other hand. Since return on the fixed income instruments is fixed, they provide the same return on the invested capital, irrespective of the economic growth of the country, depriving investors from taking advantage of the fast paced economic growth of the country.

The future of fixed income. A game you are losing:

We have already understood, how fixed income instrument are not a great way to invest money as they are heavily taxed and are negatively impacted by inflation. But this is just the beginning of it.

Interest rates around the world are falling:

Interest rates around the world are seeing a steep fall making it difficult for savers to maintain their purchasing power. If we look at the history of all the developed economies, almost all of them have seen a steep fall in interest rates. Why is it happening? For a country to prosper, it is necessary for businesses to be competitive and provide quality products and services at a competitive price.

Since most of the businesses depend on borrowed money as a source of capital, lower interest rates help businesses provide goods and services at competitive prices without compromising the quality.

In the past 30 years, the interest rates in all the developed economies have seen a steep fall. Countries like US, UK, Germany, and Singapore are providing loans at lowest interest rates ever. In countries like Japan, the interest rates are negative, which means banks charge money from depositors instead of paying interest.

Below are the interest rate trends of the major economies around the world:

Interest rates in India have the same story:

Post liberalization, India has also seen a gradual fall in interest rates which has become steeper in the past 5 years. Being a developing economy, India has to lower borrowing rates in order to support and nurture business environment.

This will directly impact bank depositors, as banks will have to cut down interest rates on deposits to maintain their interest margins. Clearly the future belongs to borrowers and savers will be at a huge disadvantage if they chose to invest in bank deposits for their long term investment.

Conclusion:

Its hard to admit, but fixed income instruments are losing their reputation as a great source of passive income that they enjoyed in old days. The sooner we accept it as a reality, better it will be for our financial well being.

However, these instruments can still be used a parking place for your money till you find a great investment opportunity. Relying on these instruments as a good source of capital appreciation and passive income will leave you with nothing else but to regret.