How To Position Your Debt Portfolio for Smart Gains

Jan 24, 2012

Two years ago on Wednesday, 20th January 2010, the BSE-Sensex closed at 17,051.

On Friday 21st January 2012, the Sensex closed at 16,739.

In the last 2 years, the Sensex has effectively moved sideways and experienced range bound volatility along the way.

Long term, savvy investors have taken any dips as opportunities to buy equities both directly and via mutual funds and will wait for the markets to recover to make their gains in equity. But what about the gains to be had from debt?

In its zeal to battle soaring inflation, the Reserve Bank Of India (RBI) hiked the repo rate (the rate at which the RBI lends funds to the system) by 375 basis points since March 2010 bringing us to the peak of the interest rate cycle today. Going forward, we can expect liquidity to be slowly eased into the economy to boost growth, and when that happens debt funds can start significantly contributing to your wealth building process.

The rule with debt funds is simple. When yields fall, prices rise, and vice versa. As the RBI cuts rates and interest rates start to go down across the board, investments in debt mutual funds will start to make money as prices of these instruments go up. If your portfolio is diversified across the asset classes (equity, debt, property and gold), and the debt component of your portfolio is geared for gains, then the coming year will go very smoothly on the debt side.

There are 2 main things you need to know when considering debt investments:

1. If a life goal is less than 3 years away, invest in debt.
   At the heart of every investment is a reason for making the investment. You have invested not just to become rich, but to use that wealth for a purpose - maybe your retirement, your child's education, purchasing another property, or any other life goal you might have. These goals will have different tenures – your retirement might be farthest away, while purchasing another property might be in the next 2 years. For a short term goal i.e. less than 3 years away, exposure to equity market volatility is not advisable. For goals of these tenures, capital protection is a must, with safe returns. Debt instruments are the way to go.

2. Diversify within debt

   Before investing in debt, ask yourself the following questions:

   1. What are your liquidity needs?
   2. What is your investment time horizon?
   3. What level of debt-related volatility can you handle with commensurate returns?
   4. What is your post tax return going to be?

If you need liquidity in your investment, a locked in product is not for you – so we can rule out bank and corporate FDs. You can consider liquid and liquid plus funds, and other longer tenure debt mutual funds. If you don't need liquidity and can lock in for a period of time, consider bank and corporate FDs and high rated NCDs. Currently, highly rated corporate FDs are offering 10% p.a. interest.

If you have a very short term investment horizon, say less than 6 months, your best option is a liquid plus mutual fund. Considering that short term rates are high right now, this investment will not only meet your liquidity and time horizon needs, but will also give you a decent rate of return.

If you can handle debt-related volatility, and you have a longer investment time horizon, you can consider opting for dynamic bond funds, income funds and gilt funds. Keep in mind these investments are volatile depending on the movement in the interest rate cycle as determined by the RBI. Given the volatility, these instruments are also likely to give you the highest return among debt investments. Back in 2008 when the repo rate was dropped 13 successive times, debt and gold gave the highest returns among the asset classes. Long term gilt funds gave close to 28% annualized returns.

Consider your tax bracket for actual returns when investing in debt.
If you invest in an FD, the interest earned will be taxed as per your tax bracket. If you invest in a debt mutual fund and stay invested for more than 1 year (long term), your tax will be 10% without indexation (a benefit offered by the Government to help you account for inflation in your purchase price) and 20% with indexation. Remember, dividends of non-liquid funds are first taxed at source at 14.1625% and then become tax free in your hands.

Most commonly, you will need some mix of these instruments.
For immediate liquidity and contingency fund creation needs, opt for a strong liquid plus fund.
For fixed returns with a lock-in, opt for a highly rated corporate FD.
To play the interest rate cycle, invest in dynamic bonds funds now, and when the time is right - go for income and gilt funds.

Conclusion

Making gains from debt investments is not rocket science, especially at a time when the interest rate cycle is peaking. Now is that time. Debt funds are perfectly positioned to start contributing towards achieving your goals. Just remember, keep your liquidity needs, time horizon and taxation in mind.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.