Intermediate

The idea of guaranteed products in investments is certainly an attractive one. However, just like any investment, they too carry their own benefits and drawbacks.

Which are the main guaranteed return products available to investors?

There are many guaranteed return products on the market. Those most frequently used include fixed deposit (FD) accounts, public provident fund (PPF) investments, corporate or government bonds, as well as debentures.

For those investors with a very low risk tolerance, all of these investments can appear attractive. These investments take a fixed lump sum amount, require you to stay invested for a fixed period of time and pay a fixed rate of interest. During that period, you will have a guaranteed rate of return. Some of these investments provide a tax benefit too.

Who should hold guaranteed return products?

Guaranteed return products help provide a balance to a high risk portfolio. However, investors who only consider such products will find their investment portfolios failing to create wealth for them since returns from such products are modest and in some cases, not the most tax efficient.

If your risk / reward profile requires guaranteed returns, or your financial goals require regular income, guaranteed return products are a helpful addition to your portfolio. However, do not forget that the purpose of investing is also to build wealth by earning real return (return that is higher than inflation and taxes). This can only happen if you expose yourself to some level of risk. Unfortunately, there is no guarantee that the contractual rate will offer you real return.

For instance, if a fixed deposit offers 8 per cent interest while inflation is at 6.5 per cent and tax levied on the interest is 30.9 per cent, the real return will be -0.97 per cent (8% minus 6.5% minus 2.47%). This negative real return indicates erosion in the value of your capital invested (30.9% of 8%).

In general, investors looking to build real wealth and beat inflation will invest in non-guaranteed products, such as equities. Generally these products have the potential for higher returns as they are market linked, but this comes at a comparatively higher risk.

Benefits of guaranteed products:

• Investors benefit from a fixed or a mostly predictable income during the contractual period.
• It does not result in capital erosion.
• These products help balance a very high risk portfolio.

Drawbacks of guaranteed products:

• Not being linked to the market, they can miss out delivering potential returns during times when the market is rising and other products may deliver many times the return offered by guaranteed products.
• The inflation rate is dynamic, and therefore guaranteed return products may not beat inflation and may be unable to help build real wealth.
• These products can also have long lock in periods.
• They can be tax inefficient.