Sunday, July 31, 2016

Monday, July 25, 2016

Whether equity or debt - invest only after considering the risks ...

Whether you want to invest in equity or debt - please consider the risks involved. Understand the risks and manage these. Here is my article in Mid-day Gujarati explaining the risk involved in debt securities and debt funds:

The English translation is as under:

Last time, we discussed about one of the risks involved in debt securities and hence in debt funds. This time around, we would discuss another of the risks that exists, but majority of the retail investors are not aware of it.
In the debt market terminology, this risk is know as “interest rate risk”. In order to understand this risk, let us take the example of a debenture issued by a company.
This debenture was issued for a period of 5 years or the maturity of the debenture at the time of issue was 5 years. Two years have passed since and hence the debenture would now mature in 3 years.
Assume that this debenture is rated AAA – highest safety
Its face value is Rs. 100 and it bears coupon of 9% p.a. payable annually. This means the debenture holders would be paid Rs. 9 (9% of the face value of Rs. 100) every year for each debenture they hold.
Now assume that for some reason the interest rates in the economy come down – we have seen this happening in case of bank fixed deposits or recently in case of small savings or PPF – by 1% p.a..
This means, similar debentures (AAA rated debentures with a maturity of 3 years) would be available in the market offering a yield of 8% p.a.
Now when other debentures offer 8% p.a. and our original debenture, which was issued earlier is offering 9% p.a. That makes it more attractive compared to other debentures in the market.
Due to this attractiveness, investors would want to buy this debenture (We have assumed that such a debenture is traded in the stock market). This buying interest results in the rise in the market price of this debenture. The market price of such a debenture would rise to such an extent that now the return on investment in this debenture would fall to 8% p.a. Calculations indicate that the market price should rise to Rs. 102.58 per debenture.
This means that when you invest Rs. 102.58 in a debenture; earn interest income of Rs. 9 per year and get a maturity value of Rs. 100; the return on investment would be approximately 8% p.a.
On the other hand, had the interest rates gone up in the market to, say 10% p.a., our debenture’s market price would have fallen to Rs. 97.51.
As can be seen from the above example, the market price of an existing debenture falls when the interest rates in the economy go up. At the same time, a drop in the interest rates in the economy results in rise in the market price of existing debentures. Thus, there is an inverse relationship between the market price of existing debentures and the interest rates in the economy.
Now, assume the same company had issued another debenture at the same time, but for a maturity period of ten years. Hence, when two years passed from the issue of both these debentures, the two debentures would have a residual maturity of 3 years and 8 years, respectively.
If the interest rates fall by 1% p.a., one debenture offers higher interest for 3 years, whereas the other offers higher rate for 8 years. Thus, the relative attractiveness of the second debenture would be even higher and hence, the market price of the same would rise much more than the first one.
This is another fact that one should remember in case of debentures. Debentures with longer maturity witness bigger price changes when interest rates in the economy change.
The investors, who hold the debentures till maturity, do not have to worry about these changes in the market prices. They are unaffected by such changes. However, if someone needs to sell the debentures in the market before maturity, such an investor would be concerned with changes in the market prices – especially if the interest rates rise, causing the market price of the debentures to fall. At the same time, if the same investor continues to hold the debenture maturity, one would get the maturity value, as this is the contracted value.
While the debenture holders may hold the debentures till maturity to avoid the interest rate risk, debt mutual funds cannot. As we have seen earlier, the investors in (open-ended) mutual funds are allowed to transact at NAV linked price on all business days, the calculation of fair price must happen on a daily basis. For this purpose the NAV calculated on a daily basis must value all the debentures at the prevailing market price. Hence, an investor investing in a debt fund may witness frequent changes in the NAV of the fund. Having said that, such an investor would be better off holding the fund units for a recommended holding period in order to reduce the impact of interest rate risk.
A debt fund investor can also decide how much interest rate risk one wants to take. As we saw some time ago, debentures with longer maturity are more sensitive to changes in interest rates compared to those with shorter maturities. An investor can check the average maturity of a debt fund and decide to invest in one with low average maturity in order to avoid interest rate risk. An aggressive or a savvy investor, willing to take the interest rate risk may choose a debt fund with long average maturity. The details of a fund’s average maturity may be seen from the fund’s fact sheet.
Understand the risk in debt funds and take an informed investment decision.
-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Monday, July 11, 2016

Not defining a goal likely to land you in a financial mess

Yesterday Portugal won the EUFA European Championship 2016 by defeating France in a close encounter. The final score read 1 - 0. While we still have good memories of the matches that were played between some great players of recent time, here is a write up regarding one very important lesson we can learn from football and apply in our financial lives.

Click on the link below to read the article:

Not defining a goal likely to land you in a financial mess

Questions on investments answered

Click on the link below to read the transcript of the chat on

Equity investments simplified

Chat on today

Have questions regarding investments in mutual fundas? Join me on for a live chat session today at 4 PM.

Are debt funds totally safe?

Are debt funds totally safe? Or do they carry some risk? Click on the link below to read my article in Mid-day Gujarati today.

The English translation is as under:

Debt mutual funds – are they totally safe?
Is there a mutual fund option for someone, who does not want to take any risks? Well, there are many investors that keep asking this question. Very often, they also think that only equity funds are risky and that there is no risk in debt funds. Since debt funds invest in debt securities, these funds are exposed to the risks associated with such securities.
Today we will discuss a very important risk related to debt securities and other fixed income investments. In the language of investments, this risk is known as the default risk or credit risk. This risk is strongly associated with debt securities and other fixed income investment options.
As we understand, when someone invests in a debt security, i.e. a debenture or a bond or a similar instrument, e.g. a fixed deposit, one is lending money to someone in need of it. In case of debentures, bonds and fixed deposits, the borrower would generally be a company, a bank or a Government.
The borrower is required to pay interest to the lender, i.e. the investor. This interest is the income for the investor. This interest payable is agreed upon right in the beginning, along with the time schedule of the payment.
However, there is a possibility that the borrower may not return the money in time. This possibility is known as the default or credit risk. Such a risk is inherent whenever the borrower is anyone other than the government of the investor’s country. The risk, simply stated, is the possibility that the borrower does not pay up the dues as per the agreed schedule. The key phrase here is “as per the agreed schedule”, which means both non-payment and delayed payment are covered.
There are two factors leading to this risk – the ability and the willingness of the borrower. While willingness is difficult to measure, the ability can be measured through the financial statements, especially in case of a company. This is done by the credit rating agencies and they assign credit rating to the various debt papers issued by the borrowers for the purpose of lending. Please remember, the rating is assigned to a paper and not to the issuer.
Between short term and long term borrowing, one may consider the long term borrowing to be riskier as the uncertainties rise with the increase in the term of borrowing. Similarly, if the borrowing amount is small, the ability is higher than if the same is large. Companies may also issue debentures backed by the security of asset. Such secured debentures may enjoy higher rating than an unsecured paper issued by the same issuer.
Though credit rating could be a good starting point to evaluate whether to invest in certain debt papers, the risk does not completely go away even with the highly rated papers. The risk keeps rising with the drop in credit rating. A proven and time-tested method to reduce such risk is to diversify across various issuers. The ability to repay is less likely to suddenly drop across different companies operating in different businesses and industries.
This risk is present in all debt securities, as already mentioned earlier. The only issuer that is considered to be free of this risk is the government of a country, since it is authorized to print currency in case the need arises. For any other entity, the risk is higher than zero.
Debt mutual funds invest in debentures, which carry this credit risk. Hence, the debt fund investors are also exposed to this risk, indirectly. If a debenture in which a debt fund has invested defaults, i.e. does not return the money in time, the NAV of the debt fund would drop to that extent.
However, there are two major reasons that reduce this risk for debt funds:
1.     A professional fund management team evaluated which securities to invest in. being a professional, the fund manager is likely to do a better job than most individual investors.
2.     By regulation, the debt fund portfolio needs to be diversified across issuers. As we discussed earlier, diversification also reduced the risk of default.
Apart from that, an investor can evaluate which schemes to invest in based on (1) the investment objective as defined in the offer document and (2) the portfolio as disclosed in the monthly fact sheet of the fund.
A very important piece of information in the fact sheet is the rating profile of the fund, which shows how much is the scheme’s exposure in what type of credit rating. If the investor is uncomfortable with high exposure in lower rated papers, one may avoid the scheme altogether.
Debt funds, though not risk free, are a great way to invest for the conservative investor, as the risk of default is managed through professional fund management and diversification.
-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.