Build portfolio with bonds of different maturities to reduce liquidity risk

When interest rates are on the higher side, investors try to lock into the best available rates (see table: Best FD rates across tenures). If they invest the bulk of their money in bonds that mature at around the same time, they could create a high degree of liquidity and reinvestment risk in their portfolios.

Liquidity refers to how quickly an investment can be converted into cash. A person who has invested in bank fixed deposit (FDs) can raise money within a couple of hours. Someone who has invested in illiquid bonds may find it difficult to sell them at all. Liquidity also refers to the cost the investor incurs to convert his investments into cash, the cost being higher in instruments with poorer liquidity. If you withdraw money prematurely from an FD, say, after just one year instead of the contracted three, the bank will pay you the interest rate for one year, and it may also charge a penalty (by reducing the one-year rate by another, say, 50 basis points). Similarly, a person trying to sell an illiquid non-convertible debenture (NCD) in the secondary market may have to sell at a heavily discounted price. To avoid the cost of liquidity, the investor should ladder his fixed-income investments.

Laddering means investing money in bonds that mature at different points of time. Thus, instead of investing Rs 3 lakh in a three-year FD, an investor could invest Rs 1 lakh in three FDs maturing in one, three and five years respectively. If he needs money in the interim, say after six months, he can encash the one-year FD. If he had invested in one FD of Rs 3 lakh, his entire corpus would have been subject to penalty. In the laddered portfolio, Rs 2 lakh in two FDs keeps earning interest at the contracted rate. Says Joydeep Sen, founder, Wiseinvestor.in: “Laddering helps the investor match his cash flow requirements with the maturity of his bonds.”

 

Laddering can also help investors deal with reinvestment risk. In a high-interest rate environment, as said earlier, investors tend to park all their money at the best rates. But interest rates move in cycles. If all the money matures at the same time, say, when interest rates are at a bottom, the investor will be forced to reinvest his entire corpus at those low rates. “Bond investments should be spaced so as to mature in a staggered manner,” says Adhil Shetty, chief executive officer, Bankbazaar. By laddering, the investor can reinvest his corpus at various points of time. Over time, he will be able to average out the interest rate he earns on his portfolio. Sen suggests that when interest rates are expected to come down, investors should go for bonds of longer maturities to lock into current higher rates. When they are expected to move up, they should invest in shorter-maturity bonds, so that they can roll over into new bonds offering higher rates a few months later.

Senior citizens can use the concept of laddering when investing in Senior Citizen Savings Scheme (SCSS) also. The tenure of each deposit is five years and one can invest up to Rs 15 lakh. The interest rate at the time of depositing continues till maturity. Investment in SCSS up to Rs 1.5 lakh qualifies for tax deduction. A senior citizen should put, say, Rs 3 lakh a year for five years. This will help him earn tax deduction for five years. From the sixth year onward, he will get regular cash every year as his first instalment matures. Since his investments are spread out over five years, he will also avoid the vagaries of the interest-rate cycle.