Fixed income investments refer to investments which promise upfront the returns of interest and principal. For very strong entities, like the Government, there is little risk of default on these promises to pay. Therefore, on a horizon matching the maturity of these investments, one knows exactly what one will get and there is no risk of returns different from those promised. For a short-term government obligation, there is no risk of loss in the nominal value of the investment and therefore these investments are often referred to as risk-free investments. For longer maturity fixed income investments, the value will fluctuate on a day-to-day basis as interest rates fluctuate. As interest rates go up the value of the investments will go down and as the interest rates go down, the value of the investments goes up. The longer the maturity of the investments, the more the fluctuation in value. However, unlike equity investments, while the value fluctuates on a day-to-day basis, the maturity value is fixed, and the value will converge to the maturity value.
Does this mean that fixed income is without risk?
No. There is no risk if one is interested in nominal returns with a horizon equal to the maturity of the investment. However, over a horizon different from that of the maturity of the investment there will be fluctuations in value and therefore risk. However, this risk is much lower than for equity investments.
The second factor that creates risk for fixed income investments is that most people are concerned over long horizons with the real value of their investments. Since inflation over time is both significant and potentially volatile, investments in fixed income do not eliminate risk in real terms. While there are options to invest in real or inflation linked fixed income investments and these can eliminate inflation risk over a term equal to that of the fixed income investment, for taxable investors even these do not eliminate inflation risk completely because income taxes will be due on nominal returns and high inflation will result in negative after-tax real returns even after investing in inflation linked fixed income investments.
Often when economies are doing well, equity markets go up and interest rates go up and the prices of fixed income investments go down. Conversely when economies do badly, interest rates go down and the value of fixed income investments go up. Adding fixed income investments therefore diversify an equity only portfolio. Fixed income investments are also less risky than equity investments, particularly in nominal terms and generally also in inflation adjusted terms.
Unexpected increases in inflation generally have a negative impact on the value of both equity and fixed income investments. There can therefore be situations where fixed income investments fail to diversify an equity portfolio.
Short-term fixed income investments for someone with a short horizon have no risk in nominal terms. For those with a longer horizon, there is no risk in nominal terms to the horizon but there is risk in nominal terms to different horizons than the maturity of the instruments. The risk of fixed income is typically much lower than for equity, particularly over short and medium-term horizons. However, in cases of unexpected hyperinflation such as was experienced in Germany, Hungary and Zimbabwe and more recently in Venezuela and Argentina, over longer periods, the value of fixed income investments can be totally decimated in real terms being more exposed to risk than even equity, because equity has a better chance of compensating for hyperinflation over longer horizons through the ability to adjust prices and revenues to inflation. In India over long periods of time, inflation has substantially degraded the real value of fixed income investments.
This is the reason why we believe that there is no asset without risk in real terms.
