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Liquidity Risk
Investments in fixed income assets are usually considered less risky than equity. Even within that, government securities are considered the safest. In order to avail the full benefits of the investments, or to earn the promised returns, there is a condition attached. The investment must be held till maturity. In case if one needs liquidity, there could be some charges or such an option may not be available at all.
Here is an example. Assume that an investor has invested one’s money in a safe investment option, a bank deposit for a goal that is due five years from now. For such a goal, one chose to invest in a five-year fixed deposit. As is clear, the term of the deposit is five years, and the promised returns would accrue to the investor only if the money is kept in the deposit for the entire period. In case, for some reason the investor needs the money before maturity, there could be some deduction in the interest, which reduces the investment return. Some other products like PPF (Public Provident Fund) may offer no liquidity for a certain period, and even after that, there may be only partial liquidity.
This risk is also very closely associated with real estate, where liquidity is very low, and often it takes weeks or months to sell the investment.
Some investment options offer instant access to funds, but the value of the investment may be subject to fluctuations. Equity shares, listed on stock exchanges are an example of this. While it is easy to sell shares to get cash in case of a large number of listed shares, the equity prices go up and down periodically. Such investments are not appropriate for funding short term liquidity needs.
Credit Risk
When someone lends money to a borrower, the borrower commits to repay the principal as well as pay the interest as per the agreed schedule. The same applies in the case of a debenture or a bond or a fixed deposit. In the case of these instruments, the issuer of the instruments is the borrower, whereas the investor is the lender. The issuer agrees to pay the interest and repay the principal as per an agreed schedule. There are three possibilities in such arrangements:
(1) the issuer honours all commitments in time, (2) the issuer pays the dues, but with some delay, and (3) the issuer does not pay principal and the interest at all. While the first is the desirable situation, the latter two are not. Credit risk is all about the possibility that the second or the third situation may arise.
Any delay or default in the repayment of principal or payment of interest may arise due to a problem with one or both of the two reasons: (1) the ability of the borrower, or (2) the intention of the borrower. While the ability of the borrower, if the same happens to be a company, is a function of the business stability and profitability of the company. Stable companies, which may be market leaders in their respective segments, may pose a lower risk, in comparison to a new company, or a small-sized company in the same industry. Some industries may also exhibit higher stability in comparison to some other.
A lender tries to assess both before lending the money or expects enough compensation in case the ability appears to be low. In the case of debentures or bonds, the investor would expect higher interest from bonds with low safety.
In this context, the bonds issued by the government of their own country would be considered to be the safest for investors. Such bonds normally offer the lowest interest rates for the citizens of the country, due to the high (highest) safety of capital. All the other bonds/ debentures available in the country would offer a higher rate of interest.
Disclaimer:
The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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