The promise of higher returns can be deceptive. Investors need to be careful
The promise of higher returns can be deceptive. Investors need to be careful
Rajesh requested his colleague Parag to lend him ₹400. Rajesh assures Parag that he will return the amount in the evening, when he will get a chance to withdraw money from the ATM.
Rajesh had only ₹2000 note and needed change for lunch etc. They have been friends for years and it was a small thing. Had Rajesh said, “I will pay you tomorrow,” Parag wouldn’t have worried.
In this case, the credit risk for Parag, i.e. the probability of Rajesh not repaying the amount, was negligible. Even if Rajesh had forgotten about it, Parag wouldn’t have bothered.
tenure, risk
Suppose Rajesh had said that he would repay after three months, Parag must have found this strange. He may not have declined Rajesh’s request to lend money but a question may be rising in his mind; This would mean that there was a credit risk. Still, Parag may have lent the money. The first principle of credit risk is, as the tenure increases, credit risk increases.
familiar with the borrower
Now, suppose the peon of a neighboring office asked Parag for ₹400. Unless Parag knew the peon, he might have declined or was a little reluctant to lend.
The next factor to keep in mind is the familiarity of the borrower. If the borrower is not known, there is greater risk.
The above examples were of money lent without any kind of collateral. Many a times, money is lent against a security, for example, when we lend money to someone by asking for some kind of security from the borrower. Here, apart from the borrower, we also evaluate the quality of the item(s) being offered as security; If we lend money to someone against gold, we want to evaluate the quality/purity of the gold.
There are many factors we consider before lending money. We do this because we want to ensure that the money lent is returned to us back and on time. Also, if we have to pay any interest, we would like it to be paid on time. All these checks are meant to reduce credit risk.
Just as we lend money to individuals, we also lend to banks; When we deposit money in savings bank account, invest in fixed deposits etc., we are actually lending them. When we invest in bonds, debentures etc., we are actually lending money to the institution that issues them. It is important to evaluate the risk associated with that borrowing. We have to verify how safe the principal is and ensure timely payment of interest. This can be verified by reading the offer document in detail. Get details of the institution, its past performance, what is its rating – there are rating agencies that rate the safety of principal and timely payment of interest – whether the amount borrowed is secured against certain assets and What is the quality of those assets.
Many a times I am asked about investing in a particular type of bond or debenture as they are giving around one or two per cent higher returns. “My standard answer is, how much are you investing and how much will you make in terms of money?”
Let us understand it with an example. Let’s say a person wants to invest ₹10,000 in a bond which is returning 2% p.a. more than the fixed deposit of the bank. Bank deposits are always safe. Higher return in terms of real money means it is ₹200 more in a year.
The investor has to decide whether for more than ₹200 per annum, it is worth taking the additional risk. Also liquidity, i.e. ease of encashment in case of bonds is either not possible or cumbersome.
A credit risk is the risk of default on a loan that can arise from a borrower failing to make required payments. Therefore, many a times, in the greed of the promise of higher interest income, we take unnecessary credit risk. Always remember, the higher the interest rate, the higher the risk.
(The author is a Financial Planner and author of Yogic Wealth)