It's not for the get-rich-overnight. In fact, it's not even for the modestly ambitious. But investing in debt is probably the surest way of steering clear of stockmarket chasms that can swallow even the savviest of investors.

By Dilip Maitra

The temptation proved irresistible for Santosh Nayak. The 41-year-old, a senior clerk in a Mumbai-based consumer electronics company, never parked his money with anyone other than government-owned banks. A man of modest means, he put the safety of money above fat, but risky, returns. But early this year, Nayak made an exception to his Spartan investing rule. He plonked down Rs 20,000 on two mutual funds that invested in hi-tech companies. He didn't need a sales pitch from the funds. Glorious examples of the funds' success sat a few feet away from him in his own office: his two colleagues, whose Rs 10,000 investment in the equity funds had swollen to Rs 70,000 in less than a year. ''I never thought that making money could be so easy.''

As Nayak quickly learnt, it isn't. The Net Asset Value (NAV)-or the market price-of the funds in which Nayak invested is down to Rs 6 from Rs 10. For Nayak, it means that his Rs 20,000 investment is now worth just Rs 12,000-a loss of Rs 8,000 in four months. Frustrated, he is now cursing himself for succumbing to ''greed'', and has vowed never to invest outside a bank-ever.

Across the country, there are thousands of risk-averse small investors like Nayak who took to equity mutual funds in the belief that they are relatively safe. Having seen their NAVs plummet by 30 to 50 per cent, these investors are now realising that an equity fund is only as safe as the stocks it invests in.

So, what should people like Nayak do? Put their money in bank fixed deposits and trade peace of mind for piffling returns? May be not. For, with interest rates headed south, it doesn't make economic sense to let your money idle away in fixed deposits (FDs). A six-month FD today fetches a bare 7 per cent return. The rate is 8 per cent for a one-year FD, 9 per cent for 2 years, and 10 per cent for 3-5 years. Says B. Pramod, 51, General Manager, Syndicate Bank: ''The steady fall in interest rates has made bank FDs a relatively less attractive investment option.'' Instead, investors like Nayak should look at several other fixed-income options available. These investments are as safe as bank deposits, but offer reasonably high rates of return. Business Today walks you through some of the investment opportunities in debt and debt-related instruments, and shows you how to negotiate the risk-return trade-off involved in each one of them.

Post-office schemes

Believe it or not, despite the 1 percentage point reduction in the interest rate, the investment schemes offered by your good old post office are some of the safest and most rewarding. If you are a tax payer, and need to invest to save tax under Section 88 of the Income Tax Act (it allows 20 per cent of the money invested to be tax deductible), then one of the best investment options is the Public Provident Fund (PPF) of the postal department. PPF is a 15-year scheme and withdrawals are permitted annually beginning the 7th year. The interest that is earned from PPF is tax free and exempt from wealth tax.

Under this scheme, in one financial year, one can invest a maximum of Rs 60,000 (and a minimum of Rs 100) in lumpsum or in monthly instalments. The investment carries an interest rate of 11 per cent compounded every year.

Sounds low? Not quite. If you take into account the tax rebate of Rs 12,000 on an investment of Rs 60,000, the return works out to as high as 31 per cent in the first year, or close to 15 per cent every year for the seven-year lock-in period. Says M.R. Madhavan, 30, Head of Fixed Income Research at ICICI Securities and Finance Company (I-Sec): ''All the savings schemes from the post office are almost 100 per cent safe, because the Government Of India is the borrower. Besides, you get very good returns.''

Another good tax-saving scheme from the snail-mail people goes under the name of the National Savings Certificate (NSC). Extremely popular for the safety and return it provides, the NSC has no upper investment limit. Like PPF, only 20 per cent of the money invested is eligible for tax rebate. And, encashment of the investment is allowed only after six years. But by the end of the period, the investment grows by an impressive 90 per cent. In other words, a Rs 10,000 NSC becomes Rs 19,012, denoting a compound interest rate of 11 per cent and a simple interest rate of 15 per cent. Since there is a six-year lock-in period, the interest earned on NSCs is also eligible for tax rebate.

The problem, however, with PPF and NSC is that these investments are not liquid enough. Besides, they are not tradeable, and can be encashed only at post offices. But if you are hard-pressed for cash, you have the option of mortgaging both PPF and NSC to raise money from banks, who give up to 60 per cent of the face value as loan.

If you are retired, and need to supplement your monthly pension with an additional interest income, then you should consider the post office's monthly income scheme. This allows a person to deposit a minimum of Rs 6,000 and a maximum of Rs 2.04 lakh in a single account, or Rs 4.08 lakh in a joint account, for six years. The money earns monthly returns at the rate of 11 per cent a year. So, if you invest Rs 2.04 lakh, you will get Rs 1,870 a month. Besides, the deposit earns a 10 per cent bonus at the time of maturity after six years. Therefore, the actual yield works out to 12.66 per cent. You could cancel the deposit after one year, but there's a 5 per cent penalty on the principal and the interest for doing so.

However, if you are patient enough and don't touch the deposit for at least three years, you can avoid paying the penalty and, on top of it, pay no income tax. Says J. Rajagopalan, 40, Director of the Mumbai-based Bluechip Corporate Investment Center, a large investment advisory for individuals: ''The post office savings schemes have become so attractive that people are withdrawing their money from banks to deposit in post offices.'' But the problem with such schemes is that they are managed by a not-so-efficient staff; the infrastructure lacks computerisation; and the style of functioning is antique.

The Life Insurance Corporation of India (LIC), the state-owned insurance giant, also has an interesting regular income scheme that is designed mainly for people on the verge of retirement. Under the scheme, called Jeevan Akshay, a person 50 years old or more can deposit in multiples of Rs 1,000 and obtain a fixed monthly pension at the rate of 12 per cent (Rs 100 per month on a deposit of Rs 10,000) for the rest of his life. In case of the investor's death, the nominee gets the entire amount that has been initially invested. The added benefit of this scheme is that the investment is eligible for a tax rebate under Section 88 and the interest income it generates is tax-free.

Mutual funds

Sure, the schemes offered by the post office and the LIC are safe, tax-efficient, and some of the best in terms of returns. But when it comes to liquidity, these schemes are as illiquid as your mother-in-law. So, if you are somebody who needs to have big money in rotation, it would be a terrible idea to lock up Rs 10 lakh in, say, NSC. In addition, you run the risk of being saddled with a falling interest-rate regime. In developed economies, for instance, interest rates are wafer-thin at 1 to 2 per cent.

If India goes the western way, interest rates will change more frequently, compared to the twice-in-a-year change now, thanks to the Reserve Bank of India's credit policy announcements in April and October. Says S. Venkateshan, 50, Executive Director (Finance), Sundaram Finance: ''The days of fixed long-term returns are gone.''

In an uncertain world, it makes sense to rely on experts to minimise risk. Enter, the friendly neighbourhood debt-fund manager. Agreed, compared to equity funds, debt funds are easy to build and manage. But with the variety of instruments in the market growing, this portfolio management is best done by a professional. Predicts Nilesh Shah, 32, Chief Investment Officer, Templeton Asset Management: ''Investment in debt instruments is going to get more and more complex in the future.'' Investors seem to agree. For, in the last three years, they have poured in Rs 13,667 crore into the 82 debt funds that have come up in that period.

Any fund manager will tell you that there are, broadly, three types of debt funds through which mutual funds channelise investments from individuals and corporates. These are: plain vanilla bond funds, gilt funds, and liquid funds. Gilt funds are the safest since they only invest in government securities. Liquid funds buy short-term instruments like commercial paper, treasury bills, and certificate of deposits.

Both gilt and liquid funds are of recent origin and, hence, are relatively small in size. The biggest among debt funds is the bond fund, which primarily invests in corporate, institutional and public sector debt papers, popularly known as corporate bonds. Some of the prominent bond funds in the country are: Birla Income Plus (asset size: Rs 1,920 crore at the end of 1999-2000) promoted by Birla Mutual; Prudential ICICI's Income Plan (Rs 1,753 crore); UTI Bond (Rs 1,001 crore), Templeton's India Income fund (Rs 875 crore), and DSP Merrill Lynch's bond fund (Rs 799 crore). All told, the bond funds boasted an asset base of Rs 10,400 crore in 1999-2000.

Bond funds

All three funds are open-ended, implying that an investor can get in and get out at any time he wants. Typically, bond funds are meant for risk-averse investors, who are looking for returns better than what the banks offer. These funds, on an average, provide a rate of return between 11 per cent and 13 per cent.

Of course, in the past, some bond funds have done better than the average. Take, for example, Birla Income Plus. It has given a 14.7 per cent return in one year and a 16.3 per cent return in the last three years. Sun F&C's Money Value Fund (dividend scheme) declared two dividends of 7.5 per cent each in 1999-2000 taking its total dividend to 15 per cent. Points out Dileep Madgavkar, 37, Chief Investment Officer, Prudential-ICICI Mutual funds: ''Our income plan appreciated 14 per cent over the year (in 1999-00) and 13.86 per cent over the (last) quarter.''

Investing in bond funds is relatively safe, although there are two kinds of risk involved: credit risk, and market risk. Bond funds try to reduce the credit risk by spreading their investment portfolio across a range of offerings. For instance, by building a portfolio that has private sector corporate bonds, public sector bonds, institutional bonds, government securities and commercial papers. Prudential ICICI's Income Plan, for example, has invested 66 per cent of its asset in corporate bonds, 27 per cent in government securities, and 4 per cent in commercial paper.

Even when investing in corporate bonds, these funds mostly stick to debt papers of high credit-worthiness, like that of AAA-rated companies. In fact, the industry thumbrule requires 80 per cent of the total fund to be invested in AAA rated papers.

To figure out which companies' bonds to invest in, mutual funds employ a team of researchers. This team not only gives the original investment advice, but also monitors the performance of all the companies in the portfolio. Should the research indicate the possibility of a downgrade in credit rating, the fund, typically, quickly gets out of the investment. Says Milind Nandurkar, 32, fund manager in charge of debt funds, Sun F&C Asset Management: ''We constantly churn our portfolio to optimise credit risk and maximise the return.'' If you are wondering why you, as an individual investor, cannot directly invest in these corporate debt instruments, here's the reason. Almost all of these bonds are sold in the private placement market, where the marketable lot is upwards of Rs 5 crore. (Did we hear you choke?)

As for the market risk, it is inversely related to the movement of interest rates. When interest rates go up, the price of the existing securities go down in the debt trading market, resulting in a capital loss to the funds. Exactly the opposite happens when interest rates go down. Mutual funds try to manage such market risks by shuffling their portfolio between long-, medium-, and short-term maturity papers. Points out Madhavan of I-Sec: ''In a volatile interest rates market, the return from debt funds will depend on the efficiency with which the funds manage the market risk.''

Making the most

Another big attraction of debt funds is their tax-efficient returns. For somebody in the high tax bracket, dividends are an easy way to avoid tax. That's because the tax on dividend is paid by the issuer, and not the recipient.

However, if you want returns by way of capital appreciation, then you should stay invested at least for one year and one day. Why 366 days and not 365? Staying invested for more than a year allows the investor to take advantage of the provision in long-term capital gains tax rules. The indexation facility allows capital gains to be discounted at a rate equivalent to that of the consumer price inflation index. Explains Nandurkar of Sun F&C: ''Based on the long-term capital gain tax of 10 per cent, the tax on a 12 per cent yield will be around 1.2 per cent while the effective tax on interest earned from banks or corporate deposits will be about 4 per cent.''

Yet another advantage of investing in debt funds is their liquidity. An investor can cash out within three to four days, by selling out to the fund. The money gets safely credited to the investor's bank account. Of course, some funds do charge a fee (called the exit load) when an investor sells out within 6 months or 3 months of the entry. But the penal fee is low, and varies between 0.3 and 0.5 per cent. Says N.K. Sharma, 48, Senior Vice-President and Chief Of Business Development, Birla Mutual: ''The beauty of mutual funds is that you get the money back when you want it.''

Sharma's taking an obvious dig at the legion of Non-Banking Finance Companies (NBFCs) and other errant companies, who have vanished after collecting hundreds of crores from unsuspecting investors. To make bond funds much more attractive to investors, funds like Templeton are planning to allow third-party like utility bills-for investors in its liquid funds.

With mutual funds bending backwards to lure investors, popular investment vehicles of yore like fixed deposits in companies and NBFCs, and bonds of financial institutions like the Industrial Development Bank of India, and ICICI, are going abegging. Nowadays, companies rarely accept fixed deposits because raising wholesale money through debentures is much more cost effective and faster.

As for the NBFCs, few today have investment-grade ratings. And those who do, like Sundaram Finan