Your money: Know the different debt securities and the risks they entail

A positive development is the increase of the insurance limit under the Deposit Insurance Credit Guarantee Cooperation for bank deposits in India from Rs 1lakh to Rs 5 lakh.

By Sunil K Parameswaran

Cautious investors, that is, investors who are relatively risk averse, prefer investments in debt securities to investments in equities. The former are considered to be more secure, because creditors have priority over shareholders if a company should have financial problems. As a result, debt securities generally generate lower returns than stocks. But there are many nuances of debt.

Rating agencies like CRISIL rate debt issues. While AAA and AA rated securities are considered very safe, low quality or low quality bonds are extremely risky. Historical data has revealed that in the United States, not a single AAA-rated security has missed a payment in the first year after issuance, over a period of more than 80 years.

Treasury securities
Treasury securities like treasury bills, treasury bills, and treasury bonds are more secure because they are backed by the full confidence and credit of the central or federal government. However, like corporate debt, G-Secs are also vulnerable to reinvestment risk from a coupon perspective, and to market risk or price risk if the security is sold before maturity. Government securities also stand out from corporate debt from another perspective, as they are generally more liquid.

A security need not be negotiable from a liquidity point of view. For example, National Savings Certificates (NSCs) are not negotiable, but an investor can pledge securities and borrow. Many investors view bank term deposits as safe investments, especially in India where most of the big banks are government owned. But with the government trying to keep a distance of dependence on the corporate sector, which includes the banking sector, it remains to be seen how far a country’s government will go to bail out struggling banks, even if they are in the public sector. A positive development is the increase of the insurance limit under the Deposit Insurance Credit Guarantee Cooperation for bank deposits in India from Rs 1lakh to Rs 5 lakh.

Debt mutual funds
Debt mutual funds are an alternative to bank deposits. Liquid funds, ultra short term bond funds and short term bond funds present relatively less price risk. And these funds hold a diversified portfolio of debt securities, which reduces the risk of default. In a mutual fund, an investor can opt for a growth, dividend or dividend reinvestment option depending on their needs. From a tax point of view, such investments may be better because they offer the advantage of indexation to unitholders.

In markets where mortgage-backed securities, which became famous due to the 2008 financial crisis, are available, investors receive monthly payments. Unlike bonds, which ultimately repay the principal at maturity, in a mortgage loan, a certain amount of principal is repaid each month. Amortized bonds are also an option for investors who wish to reduce the risk of default, as these bonds repay the principal in installments, starting well in advance of maturity. Surety insurance, if available, is also an option to reduce risk.

Retirees rely heavily on debt for their financial security. They should be well aware of the options available to them and their relative risk factors. These investors should keep abreast of tax regulations and their implications on their income.

The author is CEO of Tarheel Consultancy Services