Think investing in FDs is safe? You are wrong! Money loss likely as risk exists

Indian stock markets are seeing corrections. Many stocks have taken a hit and even market experts are not sure of the bottom. These are some reasons, why Subhash, an employee with an automobile company is now discussing if he should change his approach and "...start investing in risk-free FDs"

Subhash earns a moderate salary. Saving regularly and investing in mutual funds has been his mantra.

Most people consider FDs and debt, to be "Risk-free". Is it because the principal was not being invested in stocks, or it because FDs gave assured monthly interest? "Well both" according to Subhash. When the risks associated with investments in debt products, including the FDs were pointed out to him, Subhash was surprised, as his recent understanding led him to believe otherwise.

Default risk
His reasoning was that because the principal invested remains fixed and the interest rate is also fixed, then there is no risk. However, if the financial institution issuing the FD defaults due to any reason we may not get our principal money back. Although, such cases may be rare, the probability exists.

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Re-investment risk
There is also a re-investment risk associated with interest rate volatility. This means that if Subhash were to invest in an FD for, say five years, at 7% interest and if after two years the interest rates move upwards to 7.50%, then the existing FD would still be giving him 7% interest in the balance three-year period. So, his investment would yield half a percent less for the remaining time frame of investment. Of course, the FD can be broken to reinvest - but then there is a penalty charged by most of the financial institutions for doing that.

Liquidity risk
There is also liquidity risk. The bank or company could take a month to give back the principal money at the time of maturity.Liquidity risk means how much liquid funds the financial company has on a regular basis to meet its obligations to investors. If the company takes unduly long in meeting the obligations then the investor may not be able to meet his financial goal on time, which could defeat the very purpose of his investment. Many a times, nationalised banks do not give the provision of encashing the FD before maturity; and as such the principal is not accessible to the investor for the investment period.

Purchasing power risk
With everything from petrol to health to education getting expensive by the day, it could also be the case that inflation is more than the interest rate of your FD after three years. That can be understood as purchasing power risk as interest rates on FD rarely beat the inflation.

Plus, interest received is also taxable on 'accrual basis' and not on 'receipt basis' thereby reducing your real rate of return on most, if not all, debt investments.

Despite the risks, debt investments, including FDs, continue to remain a safer option to invest one's hard earned money. It is important to know the current rate of interest and also risks attached with the product in which we are investing. Also, investors should follow the age old principle of not keeping all eggs in one basket and should invest in different asset classes and different products within the asset class.

Now Subhash would go ahead with his decision of investing in FDs, but with a lot more conviction and confidence.

WATCH OUT FOR
If the financial institution defaults even the principal amount may not be safe  
Returns from fixed income investments rarely beat inflation and are also subject to tax 

Alisha Pokarna
(The author is a certified financial planner)

Source: DNA Money