Laddering helps you benefit from changing rates and make the most out of fixed income instruments
Fixed income investors are having a tough time predicting the movement of interest rates. The Reserve Bank of India has raised rates nine times in the last 14 months. Banks and companies, offering fixed deposits, too, have raised rates several times.
Consider this: you earned 6-7% on a one-year bank deposit a year ago, while, today, you could get about 9% to 10% on the same deposit. However, the trouble is that nobody can predict what will happen to deposit rates in the next one to two years. To tackle such a tricky scenario, financial planners recommend a technique called laddering, which helps investors maximise returns from their fixed income portfolio, including fixed deposit, company deposit, debt mutual fund schemes and so on.
WHAT IS LADDERING
Laddering is an investment technique in which investors purchase multiple financial products with different maturity dates. Laddering helps avoid the risk of reinvesting a big portion of assets if the financial environment is unfavourable.
For example, say you have fixed deposits maturing in 2012 and 2015. Now, even if the interest rate drops in 2012 when one deposit comes up for renewal, half of the income is locked at higher rates until 2015. It is impossible for retail investors to predict the interest rates. That is why laddering helps optimise returns.
HOW LADDERING WORKS
When you invest in fixed income products such as fixed deposits, one of the risk you carry is that of reinvestment. Put simply, you are not sure whether you will be able to reinvest the amount at the same rate or a higher rate when the deposit comes up for renewal. This is a risk investors have to live with in every fixed income product — be it fixed deposits or bonds.
Typically, many fixed-deposit investors try to time the market. They wait for interest rates to peak before locking their deposits. They wish bulk of their money is locked in at the highest interest rates. But they lose out on returns, since, in the interim period, they may see money lying idle in their savings bank account, earning lower returns.
Even if they succeed in this technique, when their deposit matures, they have to accept the prevailing rates at that point of time, whatever they are. If you break your fixed deposit, then you end up paying a penalty and you again land in a tricky situation. Clearly it could be a catch 22 situation!
This is where laddering helps investors. You can use it with products like bank deposits, company deposits, post office schemes, bonds and fixed maturity plans of mutual funds. So you can create a ladder with a single product such as a fixed deposit (FD) or with multiple products. It is a technique of creating a staggered income ladder, one rung at a time. Suppose you want to invest . 3 lakh of your emergency funds for an indefinite time period. You are not sure which way the interest rates are headed in the coming years. If the interest rates go up, you investment will be locked in your current FD and you cannot benefit from the higher rates. On the other hand, if the rates were to go down you would be more than content to have the money locked in at higher FD rates. So the simplest ladder is investing . 1 lakh each in a one-year, two-year and a three-year FDs. While this is the simplest ladder, you can also combine different products based on your risk profile to get a higher return.
So, a good idea could be to invest in a one-year fixed maturity plan (FMP), where you are expected to get about 9% per annum. You can also go for a two-year company fixed deposit of a reputed company like Mahindra Finance (9.5% per annum) and a three-year bank fixed deposit, which could give you about 9.5-10% per annum. The example has been used to create a three-rung ladder, but you can also build a four, five or 10-rung ladder, depending on your risk profile and needs.
BENEFITS OF 'LADDERING
Typically, a ladder is setup to have one product mature at the end of every year, which is reinvested back depending upon the period. The maturing product gives you an opportunity to invest again, depending upon the then existing interest rate scenario.
Laddering is very useful for retired people who depend on interest income to meet their day to day expenses. Laddering can free up capital as and when required. This gives you access to funds in an emergency. A person may purchase a shorter-term deposit to meet any need for capital to fund his children's education and purchase longer-term fixed deposit for retirement spending. If you ladder your fixed income instruments, there will always be some amount of money that will mature every year or after the intervals you have planned, every six or even three months, for instance.
Laddering gives you optimal return with safety of capital and liquidity. By using this process over long periods, you should be able to average out your interest rates and get a good return from your fixed income portfolio.
You can create a ladder as per your needs. Today, a ladder can range from three years to 15 years depending on your needs and wishes, since you have retail bonds from SBI, which have a tenure of as high as 15 years. So if your child is say three years old and you need money regularly for his education, you could create a 15-year ladder.
To optimise your returns it would make sense to use a mixture of instruments. Depending upon your risk-return profile, you can choose from among several products. Today, you have bank fixed deposits, company fixed deposits, retail bonds from firms like SBI, Tata Capital, Shriram Transport Finance and L&T Finance, and even postal products like NSC and Kisan Vikas Patra. You can mix and match various products to create the best ladder. The disadvantage of laddering in a falling interest rate scenario is that it may not give you an interest payout as high as you would have got by investing the entire sum at the higher rate.
But the upside is that if interest rates fall, the overall return on your corpus will still be higher than the prevailing rate of return as there will be tranches invested at higher rates. So, over the longer term, the flow will be more even and predictable.
The constant maturing, however, does present reinvestment risk to investors in a falling interest rate environment.
Happy Investing!!
We can help. Call 0 94 8300 8300 (India)
Leave your comment with mail ID and we will answer them
OR
You can write back to us at PrajnaCapital [at] Gmail [dot] Com
---------------------------------------------
Invest Mutual Funds Online
Download Mutual Fund Application Forms from all AMCs
Download Mutual Fund Application Forms
Best Performing Mutual Funds
- Largecap Funds Invest Online
- DSP BlackRock Top 100 Fund
- ICICI Prudential Focused Blue Chip Fund
- Birla Sun Life Front Line Equity Fund
- Large and Midcap Funds Invest Online
- ICICI Prudential Dynamic Plan
- HDFC Top 200 Fund
- UTI Dividend Yield Fund
- Mid and SmallCap Funds Invest Online
- Reliance Equity Opportunities Fund
- DSP BlackRock Small & Midcap Fund
- Sundaram Select Midcap
- IDFC Premier Equity Fund
- Small and MicroCap Funds Invest Online
- DSP BlackRock MicroCap Fund
- Sector Funds Invest Online
- Reliance Banking Fund
- Reliance Banking Fund
- Tax Saver Mutual Funds Invest Online
- ICICI Prudential Tax Plan
- HDFC Taxsaver
- DSP BlackRock Tax Saver Fund
- Reliance Tax Saver (ELSS) Fund
- Gold Mutual Funds Invest Online
- Relaince Gold Savings Fund
- ICICI Prudential Regular Gold Savings Fund
- HDFC Gold Fund
Posts
![[ Registered ]](http://www.diarist.net/registry/button.gif){kind=small}
No comments:
Post a Comment