Banking Balance Sheet : Part 1 : Regulatory Management

 

Banks are regulated by various agencies but the overarching principles are directed by Basel regulations . 

As per Basel's pillar 1 requirements banks need to maintain minimum ratios related to certain balance sheet and liquidity parameters. I cover those requirements in this blog. 

The balance sheet of a bank comprises of assets like loans , securities , mortgages and cash . Liabilities include deposits , secured and unsecured borrowings. Remember that banks make loans and make markets in various forms of securities (like bonds /foreign exchange) by arranging funding through deposits and non deposit (borrowings) liabilities. In course of doing this they make profits ( margin/spread) by doing maturity and liquidity transformation . That means they usually fund their balance sheet with short term liabilities to fund longer term loans . As longer term loans yields higher returns vs the short term ones , banks profit from it. But this is risky affair , it inherently exposes banks to liquidity risk . In addition banks assets are also subject to credit risk ( default , credit migration or spread changes) as well as market risk ( adverse price movements ). If that is not enough banks are also subject to operational risk due to human errors , frauds as well as usage of complex models for valuation of assets ( called model risk). All of these are nothing extraordinary and are risks of doing business. Banking regulation tries to ensure that 

1. banks maintain sufficient capital so that it can absorb losses from adverse events 
2. they maintain healthy liquidity profile

Capitalization ratios 

The focus here are on the Assets side of the balance sheet and the Equity Capital . For a moment the liablities side are explicitly ignored ( implicitly included as Equity Capital is related) 

CT1 ratio : Ratio of Tier 1 Capital /Risk Weighted Assets 

Risk Weighted assets as name suggest is assets weighted by riskiness. This measure tells us how much of the banks risk can be absorbed by its capital. The minimum required is 4.5% (though in practical use its usually higher than ~12% due to several buffers) . Which means that every 100 USD of RWA needs to be funded by minimum 4.5 USD of equity capital. 

A bank holding 100 USD of US Treasury bonds is surely less risky than a bank holding the same 100 USD in TSLA shares - and this is why we need to risk weight our assets so that its well capitalised with respect to the riskiness of its assets. 

Leverage Ratio : Ratio of Tier 1 Capital / Exposure

This ratio simply measures how much of  your assets are funded by equity capital (i.e. no risk weighting) . Minimum requirement is 3% , but practically its usually north of 4.5% in most cases. 

Overall these two measures try to restrict unchecked risk taking by banks in terms of asset quality and at the same time putting a check on how much it borrows ( leverage) comparative to its own capital strength. Historically a lot of bank failures are linked to unchecked risk taking and over leveraging and having a minimum requirements to these ratios have improved the strength of banks balance sheet over the time. 

Liquidity Ratios

Till now our focus were on assets , now we turn to liabilities - i.e. we focus on how a bank funds it operations and how stable they are comparative to their assets

Liquidity Coverage Ratio : This measure ensures banks maintain sufficient liquidity for a months cash outflow.  

Technically it states : HQLA / 30 day net cash outflow > 100% . HQLA = high quality liquid assets are basically assets that are as risk free and liquid as cash, so it simply says you have more cash than is needed by you in 30 days. 

Net Stable Funding Ratio : This is a measure of how "stable" the sources of funding are in comparison to the assets it has invested in. 

A simple e.g. might illustrate. If a bank funds a 10 year loan that it makes to an automaker by a 10 year fixed deposit from its customer , its funding is much more stable vs if it funds that same loan using a 60 day repo ( which it will need to keep rolling) . Technically it reads available stable funding / required stable funding >100% .  

The liquidity ratios are more modern than the capital ratios as regulation has traditionally focused on solvency . The idea was that as long a bank remains solvent , short term liquidity distress can be managed through intervention of central banks . Reality has been quite opposite and there are more cases of bank failures due to liquidity issues (like run on banks) despite of them being solvent. 

All of  these ratios have much more that what meets the eye and i am just scratching the surface here . But the purpose of this article is a helicopter view . I will cover them in more detail in my subsequent blogs. 

Securitization : An innovation or a scam

Securitization is another financial innovation that has impacted financial markets arguably more than  anything else in the recent past . It has provided new business models for banks , access to capital to many but has also caused dramatic amounts of systemic risks and pain especially during the housing market crashes

In this article i try to explore the mechanics , benefits and issues with securitization , in simple language. 

What the heck is securitization

What does a bank do:

If you are a bank , then your primary job is to extend credit to your customers . Credit can be in form of different kinds of loans e.g. housing , car, credit card etc. You find the money to fund this loans through deposits from other customers . So a bank essentially transforms excess savings into usable capital . In this way it keeps the economy moving by allocating resources where it generates jobs , business , growth etc.

Risk in Balance Sheet

All these loans are assets in the bank's balance sheet, i.e. they are the source of future income for the bank. However so is the risk associated with these loans. For e.g. if you default on your loan then the bank directly makes a loss. I have explained in my fixed income blog earlier , that is called credit risks. Banks do naturally price a loan considering these risks and as a result will lend cheaper to a credit-worthy individual vs a risky individual . However the risk still remains with the bank.  What if , there was a way in which banks could get rid of this risk altogether ? Surely that will find some takers 

That is where securitization comes in. 

Getting rid of balance sheet risk

What if the banks could sell these assets to individuals (like shares in the stock market) ? The banks could just originate the loan (i.e. lend to a worthy individual and price it based on analysis of risk etc.) and then sell it to investors . Banks could then make money out of these loans , and also get rid of the risk (which will now lie with the investors) . It seems viable , but there is only one small issue - why should an investor buy this ?  What is in for them . The answer is - nothing great , as a small investor i dont want to fund someone else's loans as its too risky and too concentrated. 

However as an investor , if i can get my hand on a security that is highly diversified , i.e. it contains small pieces of loans of several individuals (not a single loan to a single person) , then it reduces my risk - the chance of one person's default is much higher than 100 people defaulting together , and thats the risk reduction achieved through the diversification

So if a bank can break its total portfolio of loans into small diversified pieces - it can create a market for it , to sell them almost like shares of its loan portfolio to other investors . 

This is securitization

Figure 1: How whole loans are transformed to a diversified securitized asset (simplified for illustrations)

How to securitize

This is where it will get complex . We will need to understand what is an SPV - a special purpose vehicle. 

An SPV is a separate entity , which is sponsored by the bank , but is bankruptcy remote - i.e. it is unaffected by any financial difficulty faced by its sponsor . 

The loans the bank originates are sold to this SPV, in exchange the SPV pays cash to the bank . So now the bank has gotten rid of the loans and they have got their money back . But where is this money that the SPV pays the bank comes from ? 

Remember the SPV is a paper entity , so where does it get the cash to pay the bank for the loans it purchases ? Answer is, it issues debt , which is backed by these loans - this debt is the securitized asset as shown in figure 1 . 

So economically an end investor buys secured debt , (which is backed by portfolio of loans) and receives their share of the loan repayments as coupon , its as simple as that. 

Key benefits are as follows

- An SPV structure means the securitized debt has risk characteristics only defined by the underlying loans . It has nothing to do anything with the sponsoring bank. This is credit enhancement and protects the investors from any financial difficulty or bankruptcy of the sponsor. Credit enhancement is also achieved through overcollateralization ( e.g. issues ABS of 90m for 100m pool of loans) and the infamous tranche technique , where senior debt are subordinated by mezzanine and equity tranches providing a further cushion from some degree of defaults

- Breaking down whole loans of big size into small packets of secured debt creates a market for investors. This transforms an otherwise illiquid asset into a liquid one. This also means banks can provide more credit to the economy than otherwise and this provides almost a liquidity injection to the economy 

- Another aspect is risk reduction . The secured debt available to investors is a package with pieces of several loans. This diversification minimizes idiosyncratic risk of any individual borrower. However systemic risk still remains (i.e. a general economic collapse). In a systemic event everybody defaults and the asset is hurt, but this is rarer event than an individual default. This also helps the bank to earn the spread for the idiosyncratic risk , which it receives but do not need to pay out.   

So what's the problem then ?

Like anything - the problem lies with abuse, people have a great record of taking something wonderful and turning it into a destructive weapon ( yes i am referring to nuclear fission  ) , and the financial markets are no exception

Moral hazard

If you are a bank , and you know that on one hand all these loans will be sold to other people and will not be your risk at all and on the other hand , the more of you sell of these, the more money you make - what do you think will it do in terms of due diligence , in terms of checking credit worthiness of the borrower or quality of the collateral. The answer is obvious. You don't care much. Its important to note however that just like the theory of conservation of energy (energy is not created or destroyed, it is just transformed from one form to other) , risk of these loans are not eliminated. What was your problem are now somebody else's problem. However the problem remains , in fact it is exacerbated by the fact that the volume of credit extension  rises exponentially under this originate to distribute model. Now it seems like a ticking time bomb. 

During the housing market bubble this is exactly what happened. I was working as a mortgage broker those days. NINJA ( no income, on job no assets) loans were extended to individuals , who would most certainly default and there were some products like NegAm ( negative amortization, i.e. your principal increases with every installment you pay) , with the hope that these loans will be securitized and be "somebody else's problem" 

Illusion of Being Risk Free

I have highlighted the risk reduction capabilities of these assets , but they are certainly not risk free.

They are exposed to systemic risk , and wrong way risk ( this is for another time) , however most investors considered them as risk free. They were unaware of the inherent risk in these assets especially in a falling housing market or an economic downturn and this caused a lot of pain. This underestimation of risk , meant people made leveraged bets on these assets and in the end got obliterated .  In the peak of the cycle banks started treating these assets as cash equivalents , and lost a lot of money when many of these failed . This created a daisy chain of losses in the economy and ultimately many banks were saved with government bailout

Financial Engineering and Collusion

 

This is another problem , but needs a separate article altogether. Products like CDOs were designed to artificially (and sometimes unethically) enhance credit quality of the Securitized assets , and ratings agencies (who are paid by banks to say how good their assets are) didn't raise any alarm. 

The rise of CDS (credit default swaps) took it to another level , where people started making money betting on the failure of these assets . The Big Short by Michael Lewis tells this story well. 

Final words 

My take on Securitization is that its a great innovation. It only enhances the banks ability to do what its supposed to do - allocate capital in the economy more efficiently. It allows investors to access markets and sectors that it otherwise cannot , and it allows more credit extension in the economy which drives consumption and job creation. 

However human greed trumps everything , and i am almost certain that although great lessons were learnt from the 2007 crash, history is almost certain to be repeated in different forms. 

As an investor it means more due diligence , understanding risk characteristics of assets and not to put all eggs in a basket. 

Exploring Nifty with Altair

Exploring Nifty with Altair

 

Nifty or Nifty50 is the benchmark index for Indian stock market, which trades at the national stock exchange (NSE) in Mumbai. Nifty50 holds the top 50 public companies (by market capitalization) in India , and so in a sense it serves as a reflection of the Indian stock markets

What is Altair: Altair is a visualization and analysis library for the programming language Python which i just got introduced to. Till now i used Matplotlib for most of my work , but Altair , it seems is a worthy opponent. 

With those out of the way , lets start with the heart of the matter. 

I start with a simple time series of prices. The blue line reflects the price level of Nifty , starting from 2000 to 2022 Feb . You will see that Nifty has appreciated from a sub 1500 level to above 17000 in ~20 years . While this seems like a 10x increase in 2 decades , really the CAGR ( compound annualised growth) is close to 12% 

Now lets make it a bit more complicated in the chart below , the blue line is still the Nifty price levels , but i have added the India 10 year bold yields (red line) , and the Nifty trading volume (grey bars
) . Some interesting observations 

• Bond yields have been falling over time . From double digit yields in the early 2000s, its now around 6-7% range. 
• Its then quite natural than the stock market participation has increased over time , as investors shifted capital to stock markers from fixed income , searching for incremental yield. 
• You will see that there is a major dip in both stock prices and bond yields during the crisis periods (e.g. Lehman around 2007/8 , Covid-19 around 2020). While the stock market crash is intuitive , the crash in bond yields is perhaps a reflection of central bank monetary easing by lowering interest rates and increasing the money supply 
• It also then makes some sense that the increased money supply also found its way to the capital markets , further increasing stock market participation.  
  

Finally i end this section by examining the volatility of monthly returns of Nifty50. 

Below is a binned histogram of the monthly returns for a sample size of 266 (i.e. we have 266 monthly returns arranged in a histogram) 

Some observations we can make from these 

• Mean monthly return for this period is close to 1% (the red line)
• The central 5 bins have about 194 observations in them. So for this period, Nifty monthly returns has been between -5% and +5% almost 73% of the time (194/266). Option sellers find this kind of odds interesting to build short strategies 

Scatter plots 

A scatter plot is a great way to describe relationships between two variables and understand the strength of the statistical correlation between them . I have used this to track Nifty50 monthly returns with some other factors , which economically seems relevant. 

S&P 500

The first one is a scatter plot with S&P 500 returns in the horizontal axis , against Nifty50 returns in the vertical.

Its evident that there is a reasonably strong positive correlation , identified by the positive sloped regression line. 

Economically this is intuitive as well , S&P 500 is the benchmark for the top 500 firms in the US , which largely dominates the global stock markets. 

The emerging markets are heavily linked with the performance of the US stock markets and thats what is validated here

Crude Oil

India is a large importer of Crude oil and therefore it has a significant impact to the stock markets. In the last two decades this correlation has been positive , and this in a way seems puzzling. The general intuition is that the increase in oil price should depress stocks and vice -versa , but the data tells you a different story. Perhaps this is why numbers often help you make better judgement. 

 Generally an increase in oil price driven by increased demand signals a booming economy, leading to an inflationary environment , and that's when stocks are preferred as an asset class. So a demand driven move in oil prices have correlated positively to Nifty50. This relation do not hold when oil prices spike due to supply shocks, and then infact the relation may turn negative (this is for another day)

Gold

Gold has no correlation of statistical significance with Nifty50 under normal market situations. 

This is contrary to popular belief at the outset , but noticed i placed normal in bold . 

Under a stressed market situation (e.g. war , covid , Lehman crisis) Gold tend to be negatively correlated with Nifty. This makes sense as people prefer gold as a safe asset and resort to it in a flight to safety. 

US Dollar Index ( DXY)

This one is the favorite among many traders. The DXY as you can see is negatively related to Nifty50

In short DXY is a measure of the strength of the USD (but its not exactly a cross currency quote) , which reflects the prevailing risk appetite in the markets 

Why this relation is negative is quite complex . Firstly USD being a reserve currency is preferred at time of stress, when assets are moved from riskier emerging markets to safer havens . 

On the other hand a weakening of USD means flows into emerging markets by FIIs as their investment returns are augmented with a foreign currency return as well. 

India 10 year Bond Yields

Getting back to where i started , its natural that government bonds are negatively related to Nifty50. 

In the strong phase of the business cycle , investors prefer stocks as it helps beat inflation and preserve real growth. 

As central banks become more concerned with inflation and increase interest rates , bond become a preferable investment for two reasons. Firstly the yield is higher and secondly a higher borrowing cost impacts corporate balance sheets suppressing earnings. 

Disclaimer : I am not a registered investment advisor and neither is this blog intended for any investment advice. This should be treated for learning purposes only. 

The risk of Equity Investments

The risk of Equity Investments

My previous post was about the risks involving debt investments  ,in which we discussed issues around credit and interest rate risks . Now its time to extend this to equity investments. 

What is equity 

Equity , in terms of investments is buying ownership in a business. The investor becomes a full participant in the gains or losses the business makes , unlike debt where the investor is looking for a "certain" cash flow. 

Equity returns

Equity returns are mainly from two sources 

• Price return - If you are able to buy a stock for 100 INR and sell it for 120 INR , you make a 20 INR price return. So follows the commonly used term, buy low, sell higher.  What is important to understand is that you do not realise (i.e. encash) your profits here unless you sell off the share in the trading market. Until then the profit/ loss is a paper profit/loss. 
• Dividends - Sometimes companies return a part of their profit to their shareholders in form of a periodic payments called dividends. This is not a certain payment , though some companies maintain a stable dividend payment ratio. Also to remember here is that some high growth companies who think that their capital is better utilized in new opportunities , do prefer to do so and not pay any dividend. So it can also be said that sometimes dividend paying companies may not be a high growth company. Typically income investors invest in dividend paying stocks. 

Equity investment returns are therefore inherently uncertain , and this uncertainty is a feature rather than a bug. This writeup is all about getting a high level understanding of the uncertainties or risks facing equity investments. 

What is Risk

As mentioned earlier, risk is not a negative term. In financial markets , excess returns can only be generated by taking on risk. Risks can sometimes be avoided or mitigated (at a cost), otherwise one can also choose to take on some kinds of risk

An investor needs to understand the type and quantum of risk that are inherent in her portfolio and ensure that she is comfortable with it. Prudent risk taking is a great way to build wealth over long term

Understanding the types of risk

What i will try to introduce here is a simple framework. (Noble prizes had been won on this area and there is a vast amount of academic work done on this , but my aim is to make it simple for the regular investor and so i will not cover complex topics like the 5 factor model )

When you invest in Equity of a specific company , you are generally exposed to two different kinds of risk 

• Risks Specific to the company - E.g. say for a pharma stock, a clinical trial fail/succeed , or for a logistic firm if a warehouse catches fire or a CEO quits suddenly etc. In finance , we call this idiosyncratic risk
• Broader market related - Issues that affect the overall market , e.g. Ukraine crisis (as i write this), the COVID 19 crisis etc., inflation fears etc. These issues affects your stock , even if its doing well on its own.  We call this systematic risk

The Portfolio Context 

Investment risk is always measured in a portfolio context and the risk borne by a standalone asset is not the correct metric for risk management.  In a portfolio context , risk is not additive and this is perhaps the most important point in here. 

e.g. say you hold a portfolio of nifty50 ETF and gold equally - is the overall risk of this portfolio sum of the risks in the ETF and gold ? No its lesser. Why ? because often when markets crash in fear of something bad , people turn to gold and its value increases. So in a portfolio context the two assets reduce the risk of each other vs their standalone risk

This brings me to the point of diversification 

Diversification - a free lunch ? 

The earlier example of a gold and Nifty portfolio is a simple example of diversification. We have often heard the saying that do not put all your eggs in the same basket , and this is nothing different.

Remember the idiosyncratic risk , mentioned earlier - this can be largely avoided just by diversification 

Is it a free lunch , it can be argued either ways . When you diversify , you may loose the chance of exposing yourself more to a "multibagger" , which you can say is the cost of diversification. But i will argue that its a risk management technique. 

If your style of investing is to identify multibaggers and run a very concentrated portfolio , then there is nothing wrong , given you fully understand that you are taking on lots of idiosyncratic risk , which can go either way (in addition to the systematic risk, which is also in there)

Another style could be running a diversified portfolio of a basket of securities , where you expose yourself only to the systematic risk , and expect a return accordingly. You may gain less from multibaggers , but this also reduces the chances of a dramatic drawdown. 

If you are an investor and not a gambler, chances are that you will prioritize proper risk management over wild returns that can go either way.

Naive diversification

Say you have a 3 stock portfolio, see the 2 portfolios below

1. 33% HDFC bank , 33% Kotak bank , 33% ICICI bank
2. 33%  TCS , 33% HDFC Bank , 33% ITC 

Which of the 2 portfolios do you think is better diversified ? Chances are its the second one. 

Although both have 3 stocks each the first portfolio holds 3 stocks of similar companies (i.e. large private banks) , vs the second one is a bit better split into IT , Banks and Consumer staples. 

The point that i am trying to make is simply buying different stocks is not really diversifying well. There are a lot of interesting ways to do this including complex quantitative modelling of correlation of risk factors etc.. but there are simple solutions available. Simple broad market index ETFs (e.g. a Nifty or Sensex ETF , or a S&P 100 ETF) do a reasonable job of achieving prudent diversification of portfolio. 

Also remember - this diversification also applies to several other ways as well e.g. 

• By geography ( the US market is more than 50% share of global stock markets , India is circa 2% )
• By market capitalization i.e. large cap vs mid cap vs small cap
• Industry , as explained in the example above , sectors react differently to commodity prices and policy changes . 
• Growth vs Value stocks or momentum vs mean reverting stocks (this is for a different day) 

But all of these can be simply achieved by passive means of asset allocation and does not really require one to be a quantitative modelling expert like Jim Simons , or a stock picker like Warren Buffett.

Ultimately for any long term investor an allocation to equity is by far one of the best ways to beat inflation . Generally the problem is with wrong expectations, its the aim to get rich quick by running concentrated portfolios that has a higher chance of ruin , this is where one can avoid dramatic consequences by proper risk management 

The Risks of Debt Investments

The Risks of Debt Investments 

This is my first blog , so my aim is to keep it simple. There are tons of research and professional advice that is available on fixed income ( debt) investments , propagated by brightest of minds in the industry , but my aim is to clear out some basic factors for a common investors buy and hold debt portfolio. 

The material below is focused on an Indian investor..

What are Debt investments

The simplest way to think of this is when you lend money for interest (and principal) and not for a share of the business or venture

Bank Fixed Deposits, Government bonds, Post office bonds , RBI Bonds, Corp Bonds and infact even EPF and PPF savings can be thought of as debt instruments by nature (if not by form)

Why include Debt investments in portfolio - the common opinion

Common wisdom says  debt is low risk compared to ,say stocks or commodities or crypto

While partly correct , this is quite nuanced. Reality is complex and a notion as such like this has the potential to completely disrupt portfolios and long term goals.

In the recent past we have seen several instances of retail investors plight caused by corporate or bank defaults. A lot of these will repeat if we continue to chase higher yield without a proper understanding of the risks facing them. 

Almost all debt investments are subject to various risks and its important for an investor to understand them well. 

Risk Factors Faced by Debt instruments

Credit Risk : 

This is the obvious one. How likely do you think is someone to not return the money you had lend to them. The more that likely hood the more the Credit risk. For e.g. lets say you lend money to a business that is very stable vs one that is new and risky-  surely the credit risk is higher for the latter.

So why would you then lend to a riskier party ? Simply because you will need to be enticed with a higher reward, in form of a higher interest rate. So what i am saying here is , if some debt instrument is offering a higher interest vs another one ( all else equal) then it must be due to poor credit. 

The same logic applies to bank FDs.So if bank X offers a much higher rate than bank Y for a 5 year FD , it will mainly because X is more probable to default (i.e. not return your money). 

So naturally debt issued by central government carry the least credit risk (in India) , and as a result the lowest interest rate vs a corporate bond or a bank FD. 

The EPF , PPF also are government debts , so they carry almost no credit risk , .i.e. there is almost no chance that your PF savings will not be paid to you. But they do carry a higher interest rate ( this is for another time) , so its prudent to invest in them to the maximum extent possible. 

For corporate bonds , a credit score is used as a measure of Credit Risk . The more the AAAs the better the credit (and the lower the interest). CRISIL is a well known provider of corporate credit rating in India. As an e.g. Infosys is rated as AAA Stable vs Shriram Transport Finance as AA+ (CRISIL Long Term rating), which says INFY has a better credit rating (and lower risk), and that the debt issued by INFY may offer a lower interest rate. 

Just focusing on the interest/ yield and completely ignoring the credit worthiness will expose one to undesired credit risk , which is avoidable

Several factors like amount on borrowing  relative to equity, past repayment records , financial strength and performance contribute to determining the credit scoring for Corporates. 

Corporates sometime improve the creditworthiness of borrowing by collateralizing or other credit enhancement techniques to reduce their cost of borrowing

The bottom-line is that there is no free lunch, and an investor is better off staying away from the high yields offered by  a higher credit risk entity , unless one is fully aware of the risk . 

Interest Rate Risk : 

This is often most misunderstood by many , and i will try to explain how it works. 

As a rule of thumb fixed rate debt don't do well in an inflationary environment , or when Central Banks are expecting to hike rates. 

As i write this in 2022, the world around us are all impacted by COVID 19 pandemic and to stimulate the economy the Central Banks have reduced cost of borrowing ( how this works , is something i will cover in a different write-up) , but the bottom-line is rates are at the low end at the moment.                   

Imagine you buy a 10 year Government Bond  which pays you say 4% interest annually. This means for every 100 INR you lend, the government pays you 4 INR every year , for 10 years and then it returns the entire 100 INR. As we had discussed earlier this investment has no credit risk (backed by government is as good as the cash you use), but it surely carry interest rate risk as you will see. 

Now imagine the following happens (which is quite likely) : RBI increases the borrowing rate to 4.5% next year ( Central banks increase rates to control inflation; again a topic for another day). What that will mean is your investment that yields 4 INR is lesser than the current market yield of 4.5 INR. To put it another way your 100 INR principal is worth  96 INR now. 

1.1 Impact of Changing interest rates on Debt Investment

As illustrated in 1.1, a lowering of interest rate has a favorable impact on the initial investment, and a rate hike has an adverse impact. This is classic bond math, and in Finance we use a term called "Duration" and "Convexity" to measure the sensitivity of a bond to changing rates (not to be confused with tenure)

So as you see , the same principles applies to a bank FD/ Corp Bond , but remember that unlike government bonds, they are also subject to credit risk of the issuing bank/corporate

Floating rate bonds revise the interest applicable based on current prevailing rates - contrary to popular opinion this is less risky as its almost insulated not only from interest rate changes but also from inflation to some extent. Instruments are available (GOI floating bonds etc.) which provide these kind of terms. 

The PF investments also get their rates revised every year and in a sense are floating rate - another reason why one should maximize these buckets for the low risk portion of the portfolio.

So the conclusion, is that when economy is facing a recession or slowdown and interest rates are expected to decline in future , is the perfect time to lock in the higher interest rates through FDs or Fixed coupon bonds. When inflation is a bigger worry than growth and we are staring at a rate hike , then its prudent to not get into fixed rate bonds . If one is unsure of future trajectory of rates , then floating rate bonds are the way to go. 

There are several other kinds of risks facing the debt investor like Spread Risk , Country Risk , Term and Liquidity etc. but i choose to avoid them for now to keep it simple for our average retail investor. 

The bottom-line

• Debt investments do reduce risk (measured by volatility of returns) of an all stock portfolio, and an allocation to it is necessary to provide diversification to a retail portfolio
• Debt investments can also provide regular income - in form of interest payments , which can be desirable for income investors
• Credit and Interest Risk are the key risk factors to watch out for, while investing in debt. Remember that "risk" is not a negative term, in fact excess return can only be generated by taking on "risk" in the portfolio. The key is to be calibrated and prudent about taking on risk. 

A quick summary of the risks inherent in debt assets discussed below

1.2 Risks inherent in Instruments

Bank FDs are insured by government of India for investments up to 5 lacs and that is why i consider them slightly safer than a corporate bond (ceteris paribus) , and the EPF/ PPF have their inherent tax advantages , which is why i consider them superior for a retail investor 

That's it for now. Please leave a comment with your feedback and any topic that you want me write more on. 

Manisangsu ( pronounced Manish-anshu  )