How mutual funds reduce reinvestment risk with FMP

These FMPs will invest in STRIPS of G-Secs instead of G-Secs themselves. Here’s a look at what these strips are.

reinvestment risk

When it comes to investing in bonds, interest rate risk, credit risk, liquidity risk, etc. usually concern investors, but there is one risk that is rarely talked about – reinvestment risk.

What is this? When you invest in bonds, in addition to principal payments at the end of the bond’s maturity, you also receive coupon payments, usually semi-annually (twice a year).

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The investor may or may not be able to reinvest these coupon payments at the same yield offered by the original bond as the speed of the yield can fluctuate depending on market dynamics.

How are strips made?

STRIPS stands for Separate Trading of Registered Interest and Principal Securities. It is a process that breaks a bond into multiple securities, each security representing a cash flow, payable when due.

For example, when 6% G-Sec 100 of 2026 is broken, each coupon payment 3 (payable semi-annually), will become the principal payment of a Coupon STRIP and 100 (payable at maturity) will become the original STRIP (see graphic).

These cash flows are divided into individual securities and traded in the secondary market as STRIPS. The maturity of STRIPs coincides with the date on which the coupon or principal payment was due. For example, if the first coupon was due in six months, that particular strip would also mature in six months.

These strips are effectively zero-coupon bonds (ZCBs). Since there are no coupon payments on these securities, the risk of reinvestment at a lower yield is eliminated. The bonds are converted into strips by primary dealers, who charge 2-4 bps for making the strips. Currently, this process is allowed only for G-Sec.

Who should get FMP strips?

FMPs are close ended funds. Therefore, investors investing in FMPs should wait till the maturity of the fund. If yields or interest rates move downward, reinvestment risk can reduce the return by 20-30 basis points (bps) from the originally indicated.

For investors who are not sure that they can hold on to the maturity of the fund, Target Maturity Fund (TMF) can be an option. In order to access the liquidity in a TMF, the investor must trade in reinvestment risk.

There is an option of premature withdrawal of the fund, as TMFs are open-ended. While early withdrawals are permitted in TMFs, investors may not get returns close to the indicative yield on such exits.

Go for STRIPS FMP only when you are sure of your investment horizon and can keep the money for the entire tenure of the FMP.

BondsIndia Co-Founder Ankit Gupta has an additional tip. “Look at what level you are investing in STRIPS and what the interest rate outlook is. Are rates likely to go below current levels? Then STRIPS make sense.”

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