The Role of Fixed Income Securities in Investment Portfolio - Assignment Example

Topic: Bond Markets, Analysis & Strategy (MBA Instructions: What is the role of Fixed Income Securities in investment portfolio Will you add Fixed Income Secruities into your own investment portfolio Please explain in details. What is the role of Fixed Income Securities in investment portfolio "Don't put all your eggs in one basket" is an oft-quoted proverb. Probably, much before Mark Mobius, Peter Lynch and other financial gurus had made their debut on this earth, the wise old men of yore had thought, and thought hard to put together the said proverb. Any investment is subject to risk from various external factors. These could be in any of the following forms: Political factors Economic factors Social factors Others Political Factors Any change in the political leadership of the country/region could trigger a change in the economic scenario, specifically, bond markets. A populist government might hike the rate of interest from Fixed income securities. Another leader might want to bring down the rates of such instruments. Thus, the returns from fixed income securities remain unchanged over the period for which they are invested in. Beyond the period or before the period of investment, the rates would be prone to vary. Economic Factors Changes in the reserve ratio (CRR) stipulated by the Reserve/Federal Bank lead to changes in the rate of interest/ returns for the investor. A shift in the global economy and change in the CRR of the banks in the country which has a dominant role in the global economy can influence the interest rates in other countries too. Social Factors A drastic change in the social fabric of the country, like onset of natural calamities or man-made calamities like war, terrorism etc. can lead to a change in the returns from the investment. Types of investments An investor has a choice of investing in various assets over time. He can invest in movable assets like securities, stocks, fixed deposits and immovable assets like land, buildings etc. Each class of investment has its own risks and returns. The returns from each asset would also vary from time to time, depending on various socio-political, economic and geographical factors. Risk v/s Rewards The capital markets offer a wide range of investment options like shares, stocks, debentures, fixed income securities etc. While shares and stocks are high risk-high return instruments, bonds and fixed income securities are safer modes of investment. Capital markets typically tend to move in cycles or phases, called bull and bear phases . A bull market is one in which the majority of the shares move up and there is ample capital appreciation for the investor. A bear phase is one in which there is a negative trend and the prices of shares fall. There is erosion in value of the holding and the investor might not even get back his initial investment amount. The returns in a bull market have been known to be as high as 500-1000% in some cases, while the losses in a bear market have forced several investors to go bankrupt and sell whatever other assets they were holding as investments. Many a times, the economy of the country itself has had to undergo a substantial loss due to the fluctuations in the capital markets. Fixed income securities are one of the most innovative and dynamic instruments evolved in the financial system ever since the inception of money. Based as they are on the concept of interest and time-value of money, Fixed income securities personify the essence of innovation and transformation, which have fueled the explosive growth of the financial markets over the past few centuries. http://sify.com/finance/fullstory.phpid=14201529, accessed on 27th Aug.,2008. A wise investor would have a combination of investments which give fixed and variable returns over a period of time. The risks involved in investing in stocks are offset by the returns from fixed income securities. Depending on the disposable income, age of the investor and risk-taking capacity of the investor, a financial planner would advise him to allocate a portion to stocks, a part in the form of securities with fixed income and a part in immovable assets like land. Generally, the risk-taking capacity of the investor is inversely proportional to the age of the investor. If the investor is young and can afford to invest a high amount of his savings, it is advisable to allocate at least 50% in the capital markets and the rest in a combination of fixed income securities and land/property. Since the investor is assured of an income and need not touch the capital invested in the stock market, he can choose to wait for the markets to enter a bull cycle and withdraw his investment once the desired appreciation has taken place. A small proportion of the income can be allocated to fixed income securities to handle any emergency or as a way to repay a loan taken for some other purpose like tax-saving, entrepreneurship etc. However, if the investor is retired and needs a fixed income to survive, it is best to allocate a major part of the savings to fixed income securities. He will not only have a fixed income per month to rut h household expenses, but also have peace of mind. A small proportion of the surplus savings could be directed to the capital markets and allowed to grow over the months. Will you add Fixed Income Securities into your own investment portfolio Please explain in detail. I would certainly add Fixed Income Securities into my own investment portfolio. Since they have an assured rate of return of 10-12 % per annum, I would allocate a part of my surplus to these instruments. While huge returns from shares and stocks would certainly make me happy, a cyclical loss in a bear phase might eat into my capital itself. Economics is a subject which brings into play a lot of strategic thinking and planning. So, I would first take a loan/insurance policy which would require systematic investment over the years/months. I would invest an amount in fixed security instruments such that the interest from the same would take care of the repayment/installment of the loan/insurance policy. Nowadays, mutual funds also offer fixed return funds which have better tax saving options for the investor. So, depending on the risk I can take at that particular stage in my life, I would invest a part of my savings in Fixed Income Securities. Now that I am young and embarking on a growth phase in my life, I will invest a major part of my surplus in shares. AS and when the market goes high and I get substantial returns on my capital invested, I will pull out the gains and invest the amount in Fixed Income Securities. Thus, without having to invest a huge amount at a time, I will still be assured of good capital appreciation and practically get to invest in the fixed securities free of cost. The returns/interest from this investment will be directed to pay for a loan or insurance EMI (equated monthly installment).The initial capital can still remain invested in the market, I will only pull out the money which is the profit made on the investment. Thus, without having to invest a huge amount at a time, I still get to save huge amounts and also earn interest/ tax benefits from the same. However, as I age, the proportion of my savings invested in fixed return securities would have to go up, in order to take care of inflation, income after retirement etc. References: http://sify.com/finance/fullstory.phpid=14201529, accessed on 27th Aug.,2008. Read More