With inflation throwing the interest rates sky high, fixed income investments are expected to propel great returns. With this phenomenon expected to loom over the economy for quite some time, fixed maturity plans, mutual funds, bank fixed deposits and corporate bonds have become the stars of the season. But one must always watch out for the investment risk involved in these ventures. If interest rates have fallen at the time of the investment maturity period, the investor will be left with no option but to reinvest at that lower rate. This risk of opting for a lower rate than what one would achieve in return is known as an investment risk, and stand as the largest risk you’ll ever encounter in your investment in these fixed duration products.
When you invest in FMPs or FDs for a specific period of time, it magnifies the risk to a great extent. However, if you play smart by making an investment in a mutual funds that is open-ended, you will not have to withdraw your money from it so long you require it. While fixed maturity plans vary in maturity periods of 90, 180 or 370 days, an investor will have an effective investment period for a longer period of time. Also, fixed maturity plans are open for subscription only on certain dates. So you must park your funds for approximately 4 to 7 days in a liquid fund, and wait for the right fixed maturity plan to invest your funds in. If you invest in a fixed maturity plan with an investment period of 90 days, and at the end of the investment period, you realize that you are in need of funds at that period of time, you can invest in liquid funds for a certain period of time until you come across the right investment option. Thus, your effective investment period extends for a period of 100-110 days, and as a result, for approximately 10-20 days, you earn less money than you ideally should have earned. If, on the contrary, you invest in an open-ended fund, which is a short-term instrument, you may end up earning higher returns for your entire 100-110 days of investment period. If the interest rates of your fund plummet during your investment period, your portfolio yield will go up if you have invested in a short-term debt fund. Thus, you end up being in a win-win situation.
It is important for investors to understand that the reinvest risk creates an opportunity for investors, through which only fixed duration products can benefit from. However, it is also important to analyze the behavior of fixed maturity plans over a long period of time, i.e., in a year from now. Getting into the hassle of purchasing debt like loans, home loan etc are unnecessary if you have had the right idea about where you wish to invest and when you may require those funds. As mentioned before, when interest rates are constant over a period of time, a short-term debt fund will yield better returns as compared to a fixed maturity plan. Also, short-term debt funds will perform consistently well as compared to fixed maturity plans, when interest rates fall. However, if interest rates rise by the time your fixed maturity plan reaches its maturity, you will earn much greater returns than what you would have received through a short-term debt fund. On the other hand, from that day where the interest rates rise, if you have invested in a short-term debt fund, the running yield on your fund would rise too, and if you stay invested for a few more days, you will end up receiving the same yield that you would have received through an investment in a fixed maturity plan. Thus, short-term debt funds help an investor in deriving the maximum benefit when the interest rates are stable.