CUSHION AGAINST VOLATILITY
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One golden rule of investing is that your portfo- lio should always include fixed-income products, no matter what your age is or how interest rates are moving.
If you have not followed this key commandment of investment and failed to cushion your equity portfolio with debt funds or other fixed-income instruments, it is as good a time as any to correct the mistake, thanks to the high interest rates being offered on debt products.
Debt funds, which invest in a range of debt and fixedincome securities of different maturities and credit quality, protect you from equity market volatility and offer decent returns. Before we go into the virtues of debt funds, let’s look at why it is a good time to invest in debt.
HIGH ON YIELD CURVE
Yields on bonds, both government and corporate, are high thanks to the Reserve Bank of India’s (RBI’s) 13 consecutive rate increases since March 2010.
The yield on 10-year government bonds maturing in 2021 with 7.8% coupon rate, or interest rate, is close to 8.9%, while the yield on three-month treasury bills(T-bills) is 8.7%. One-year certificates of deposits (CDs), issued by commercial banks, are giving 9.5-9.7%.
Among other options, banks are offering up to 9.5-10% on fixed deposits, while non-convertible debentures (NCDs) are giving 12-12.5% a year.
INTEREST RATES AND BOND PRICES
Interest rates and bond prices share an inverse relationship. When RBI increases rates, bond prices fall as bank deposit rates become more attractive than the interest rates on bonds. So, many investors sell bonds in the secondary market and go for the risk-free bank deposits, leading to a fall in bond prices.
Let us consider a bond issued by XYZ Corporation with a face value of Rs 100. Assume that it promises 6% annual interest, called the coupon rate, till maturity.
In the secondary market, the bond is available for Rs 101. For someone who buys the bond from the secondary market, the current yield on the bond will be
= (Rs 6/Rs 101)X100 =5.94%. Where Rs 6 is the coupon amount he will receive if he holds the bond till maturity and Rs 101 is the price at which the bond is trading in the secondary market.
Now, suppose interest rates are increased and the price of the bond in the market drops to Rs 99.
The current yield = (Rs6/Rs99)X100 = 6.06%
So, while the coupon remains 6%, the yield changes—5.94% in the first case and 6.06% in the second—according to the market price of the bond.
An investor who bought the bond at Rs 101 can either hold it till maturity and get 5.94% annual interest or wait for the bond price to rise above Rs 101 to gain from capital appreciation.
The person who invested Rs 99 can either wait for the bond price to go up and gain from capital appreciation or hold till maturity and earn 6.06% interest on his investment.
Fund managers who take investment decisions on your behalf deal with diverse debt securities with different maturity periods.
WHY DEBT FUNDS?
Though the fixed income and debt space is attractive overall, debt funds have a few advantages over the more popular bank and corporate fixed deposits.
Choice: Mutual funds offer a range of debt funds with different tenures, investment objectives and portfolio composition. Depending on the duration and portfolio composition, debt funds are classified as liquid funds, ultra short-term funds, income funds, gilt funds, fixed maturity plans (FMPs) and hybrid funds.
Liquid and ultra short-term funds are short-tenure funds that invest mainly in short-term debt such as T-bills, call money, com- mercial papers (CPs) and CDs; income funds are medium- to long-term funds that invest in a mix of money market securities and government and corporate bonds; and gilt funds invest in high-quality low-risk government bonds of medium- to long-term maturity.
Besides, there are FMPs, which are close-ended funds, and capital protection funds and floating rate funds.
More liquid: Most debt funds are open-ended and investors can exit or enter any day. The only exception in this case is FMPs. Hence, they offer better liquidity than bank and corporate fixed deposit schemes.
Diversified portfolio: Mutual funds provide you the option of having a diversified portfolio in terms of credit quality, asset class and maturity. A debt fund portfolio can include T-bills, CPs, CDs, call money and government and corporate bonds. It can also invest in NCDs as well as corporate and bank fixed deposits. A fund manager can rebalance the portfolio according to different interest rate scenarios and offer a decent return without taking too much risk.
Better post-tax returns: Debt funds are in general more taxefficient, that is, lead to a lower tax liability, than bank and corporate fixed deposits. While inter- est earned on bank and corporate fixed deposits is taxed according to the investor’s income tax slab, in case of debt funds long-term capital gains (redemption after a year) are taxed at 10% without indexation and 20% with indexation. Those who fall in higher tax brackets can save a lot of tax by investing in debt funds and thus get better after-tax returns.
Indexation is adjusting the purchase price of debt funds for inflation on the basis of a cost-inflation index that the government releases at the start of every year. This benefit is available only on capital gains booked after one year or more.
Short-term capital gains from debt funds are, however, taxed at the income tax rate.
MATURITY MATTERS
Though it is widely believed that interest rates in India have peaked and will either plateau or decline from here, some experts still expect the RBI to increase rates by another 25 basis points before finally reversing the raterise cycle. This has left investors confused whether to invest for the short-term (6 months-1 year) or a slightly longer duration (1-1.5 years or more).
Ideally, the decision should be based on the investment objective and when you require the money. “Investors must keep their requirements in mind and check the liquidity of the available instruments,” says Harish Sabharwal, chief operating officer, Bajaj Capital.
The general wisdom is that one must invest for the short-term when interest rates are rising. “When interest rates are rising, it is wise to remain invested in short-term products to minimise the rate risk and reinvest at higher levels. When softening of interest rates is imminent or under way, it is better to invest for a longer duration to take advantage of capital gains,” says Killol Pandya, head of fixed income, Daiwa Asset Management.
Shriram Ramanathan, portfolio manager, fixed income, Fidelity Worldwide Investment, however, says that short-term income funds with good credit quality have the potential to offer best risk-adjusted returns for those who have an investment horizon of six months to one year.
SHORT-TERM STRATEGY
Invest in short-term (six months to one year) income funds which have a portfolio of debt securities offering higher yields at maturity. If interest rates fall from these levels, you can benefit either from capital gains or get high yield at maturity.
“If an investor has idle cash in his current account or savings account, he should look at investing purely in liquid funds where there is relatively lower interest rate risk,” says Lakshmi Iyer, head of fixed income and products, Kotak Mutual Fund.