One of Rao’s clients received windfall gains after his parents sold a property and gave him his share. Based on the client’s allocation and goals, Rao invested in fixed-income instruments. “We invested in such a way that the client will receive money almost every year, and can reinvest the funds based on the prevailing interest rates on maturity. This is known as laddering,” he said.
We tell you the benefits of laddering fixed-income instruments and how you can do it.
Reduces reinvestment risk: Laddering is like investing in a systemic investment plan where you get to average the cost of purchase by buying small amounts regularly without worrying about the market condition.
In laddering, you invest in such a manner that your investments mature at different intervals, and are reinvested based on the best prevailing rates at the time. So you get the benefit of an average interest rate and do not have to take a call on rate movement at a specific time in the future.
Take the example of an investor who had put money in a fixed deposit (FD) six-seven years ago which is maturing in October or November this year. The State Bank of India’s (SBI) FD rates in October 2013 and 2014 were 9% and 8.5%, respectively. If the investor decides to renew the FD now, the bank will offer him just 5.4% for a tenure of five years or more. If he would have laddered the investment in 2013, only a portion would be up for renewal now, while the rest could have continued to earn higher interest.
Creates liquidity: According to financial planners, most clients are willing to sacrifice high interest rates in favour of liquidity given the prevailing uncertainty. So, if you are not laddering, you may need to choose between lower rate and higher lock-in.
Government-backed products that offer higher rates come with longer lock-ins. For instance, government of India’s Floating Rate Savings Bonds 2020, which currently offers a rate of 7.15% (it changes every six months), has a lock-in of seven years for non-seniors. Similarly, five-year post office FDs, which has the highest rate of 6.7%, has a penalty for premature withdrawal. On the other hand, FDs by government institutions, for periods between one and three years, are giving only 5.1-5.5%.
By laddering, you will need to lock in only a part of your investments for a longer period and not the entire sum. So, an individual with ₹10 lakh can split it into five parts of ₹2 lakh each and invest in a manner that each part matures at different intervals. The shorter-term portions can serve liquidity needs and the longer-term ones can earn high rates.
“As there is no clarity whether interest rates could rise in the next year or two, individuals can choose to ladder their investments,” said Suresh Sadagopan, founder, Ladder 7 Financial Advisories, a Sebi-registered investment advisory firm.
For emergencies, it makes sense to break and pay a penalty on one or two FDs of smaller amounts, depending on the requirement, rather than paying a larger penalty by breaking one large FD and using up only part of the money for the emergency. Only some banks allow partial withdrawals.
HOW TO USE LADDERING
How you choose to ladder your investments depends on when you need the money and the interest rates on different products. It’s important to strike a balance between the two.
When you ladder your investments, don’t just rely on a single instrument like FDs. “By diversifying between issuers, investors spread the risks,” said Sadagopan. Rao, for example, invested in ultra-short term and liquid debt funds for the short term (less than a year). For the period between one and two years, he invested in bank FDs. For two to five years, he made investments in company deposits. For the long term, he used GoI bonds.
Non-banking financial companies such as Bajaj Finance are offering interest rates of 6.69-7% for one- to four-year FDs.
Laddering can be used in different ways. Some investors in the lower-income group invest a fixed amount, say, ₹1,000, in Kisan Vikas Patra (KVP) every month to generate cash flows, according to investment advisers. KVP, typically, matures when the amount doubles. At present, the investment tenure is of 10 years and four months. On maturity, investors withdraw the principal ( ₹1,000) and reinvest the remaining amount ( ₹1,000) back into KVP, generating cash flow, possibly without the need to invest more.
Though not advisable, some people also ladder their tax-saving investment such as FDs, KVPs and National Savings Certificates. They invest in five-, six-, seven-, eight-, nine- and 10-year tax-saving deposits and reinvest the amount when they mature to get fresh tax deduction.
Debt funds are a better option if you are willing to take risk. “An individual must match his investment horizon with the fund category,” said Sadagopan. He prefers debt funds as they can be redeemed as and when required and are tax efficient, so compare the post-tax returns of FDs and debt funds.
According to advisers, stick to asset allocation and goals when making any investment. Before you start laddering your investments, ensure that your emergency fund is in place and readily accessible.
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