Falling Interest Rates: Here are Ways to Manage Reinvestment Risk

Given the current situation of declining interest rates, the investment portfolios of risk-averse investors or moderate-risk takers who allocate their investments in fixed income securities have been impacted adversely.
Lower interest rates fundamentally means lower returns in the future which means that the investor’s investments shall suffer from reinvestment risk.Reinvestment risk refers to the possibility that the investor shall not be able to reinvest his or her cash receipts (income from interest/coupon) at a rate as good as the current rate. To add to this, fixed income products usually come with a lock-in period.There are various strategies that an investor can adopt in order to reduce their reinvestment risk.

Investors having a long-term holding capacity must ideally invest in tax-free bonds of public sector companies to reduce their reinvestment risk. Although investment in tax-free bonds isn’t eligible for a deduction under section 80C of the Income Tax Act of 1961, the interest earned on these bonds is tax-exempt.These bonds can be purchased from the secondary market. In case of a fresh issue, they can also be purchased from the primary market, although there hasn't been a fresh issue of tax-free public sector bonds in a while.The tax-free feature of such bonds makes them attractive as the investor’s net returns do not get impacted due to tax outgo. Such bonds are even more favourable in case of investors falling in the 30% and above tax bracket.

Despite the cut in interest rates of bank fixed deposits and other debt instruments, the rates of small savings schemes are still higher than bank FDs. Moreover, popular savings schemes such as the Public Provident Fund (PPF) and Sukanya Samriddhi Yojana have also added tax benefits, which effectively aids in yielding higher returns on investments. Furthermore, they are an ideal investment avenue in case of investors looking to build a retirement corpus.

Company deposits are investments placed by investors in deposits with companies that earn interest income at a predetermined rate for a fixed time frame. Company deposits offer higher interest rates than most fixed-income financial products, which can make them seem more attractive. However, they also entail an element of risk which pertains to the possibility of the company defaulting on repayment. Investors must be cautious about investing in company deposits and make a calculated and informed choice. In Conclusion With a change in interest rate policies, fixed-income investors will now have to modify their financial goals or realign their goals with other investments more suitable to their liquidity and income needs.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.