Personal Finance: Don't Be A Debt Junkie

Debt funds may have posted whopping returns last year, but that was because interest rates were declining; expect more realistic returns this year.

I was sitting with my neighbourhood investment advisor, generally whining about the state of the equities market, the global tech meltdown and wondering how Goldman Sachs' new economy evangelist Abby Joseph Cohen can still be so bullish about the Dow (she says it's going to reach 12,500 by the year-end), when one of his clients bursts into his office.

The markets were down in the dumps that morning, but this man oozed exuberance. A few months back, he'd opted for a golden handshake from a nationalised bank and temporarily parked a largish chunk of the money he received as settlement in a debt scheme of a mutual fund that our advisor had recommended. Three months later, he's thrilled to bits-his money has earned a return of 25 per cent in a quarter. If he'd kept it in his bank, he'd have got a paltry 4.5 per cent and if he'd put it in an equity fund....

When, after lots of back thumping and cheery hoops, his client left, my investment advisor friend looked at me and said: ''These are the new debt junkies. They've suddenly discovered how they can earn whopping returns from debt funds in the short-term.''

Most debt funds are riding high on an annualised 20-25 per cent return over the last quarter and a 18-20 per cent return over the last year. Enough incentive for investors fleeing equity funds to move their investments to debt schemes. Of course, debt funds are always attractive in a bear market, especially because of the tax breaks they offer for long-term investors. But, currently, there are lots of floating money finding its way to debt funds for short-term gains.

Why are debt funds suddenly fetching such lucrative returns? After all, they invest in bonds that cannot effectively yield more than the overall interest rate in the economy. But most people don't realise that investment in debt mutual funds also has a capital gains aspect to it. And, as with all capital gains, an inherent risk factor too. Let's take an example.

Consider a bond, with a coupon rate of 12 per cent per annum and an issue price of Rs 100. If the overall interest rate in the economy falls to 10 per cent, this bond bearing Rs 12 (on every Rs 100) as interest becomes attractive. Thus, the price of the bond will be adjusted upwards so that the effective yield of this bond is the same as any other, ie. 10 per cent.

The secondary market price of this bond will move up to Rs 120 so that the Rs 12 interest will be 10 per cent of the new price, Rs 120. For an investor who bought the bond before the interest rate fell, this could be an opportunity to book profits and thereby earn capital gains in the short term. Of course, a long-term debt investor does not benefit because he will continue to get 12 per cent on his original Rs 100 if he holds on.

But a short-term investor, who has used a debt mutual fund to park his funds temporarily, can benefit from high returns in a particular year. As interest rate falls and bond prices go up, the NAV of the fund also climbs because of the rising prices of the bonds it holds. This is precisely what has been happening in the past year.

Don't bank on it, though. It's only in a falling interest rate regime that such capital gains can accrue. Says Krishnamurthy Vijayan, CEO, JM Mutual Fund: ''The phenomenal returns of 25-30 per cent posted by debt schemes are an aberration. Those investing in debt funds, expecting last year's performance to be repeated, could be sorely disappointed. ''

Need more sobering advice? Remember that returns on a debt fund by its very nature has to depend on interest income. And in the current interest rate scenario, this cannot be more than 10 per cent. So it will be well nigh impossible for a debt fund to generate a return that is more than this rate unless interest rates fall continuously. ''That,'' says Prashant Jain, Fund Manager-Debt segment Zurich India Mutual Fund, ''is unlikely to continue over the next year or so.'' The fact that banks are not dropping their interest rates below 9 per cent for a three-year deposit will affect interest rates, specially since there is a 9 per cent rate tag on 10-year Government securities.

And by the way, if you're still prowling for short-term gains be advised of the flip side-losses. If interest rates rise this year, prices of bonds will fall in order to adjust to a higher expected yield. This will push the NAV of the debt funds down, resulting in a capital loss. Will interest rates rise this year?

The answer to that is known only to one Mr Jalan. One reason for the low interest rates is the low credit offtake in the banking system. If private sector borrowings increase (read: a recovery begins), interest rates could firm up. And, if the rupee comes under pressure (like it did recently when S&P and Moody's downgraded India's sovereign rating) and the Reserve Bank decides to prop it up, it could raise interest rates. The lesson, dear investor: don't speculate with debt.

SNIPPETS

A Supplement To Your Medical Insurance

If you are looking for a policy that can supplement your medical insurance, here's some good news: HSBC and Tata AIG have launched a hospital cash insurance plan, to ease your financial burden in case of hospitalisation. The plan has two options, one offering a cover of Rs 1,000 per day spent in a hospital. The other plan doubles this benefit (with double the premium, of course) to Rs 2,000 per day. The plan covers any number of admissions in a year and has a list of specified hospitals. One advantage of this policy is that it doesn't specify the end use for the proceeds disbursed. The money can go towards assisting family finances, to pay for medical care, to arrange for childcare and so on. The amount is disbursed irrespective of the actual expenses incurred. The policy holder will receive Rs 1,000/Rs 2,000 per day for each day that he has spent in a hospital, regardless of the actual hospital bill.

Pay your LIC Premium Through The Net

While the private insurance companies are doing their best to get a larger pie of the insurance cake, LIC too, seems to be doing its bit to retain its market. In its efforts towards customer satisfaction, LIC has tied up with two payment gateways-Billjunction.com and Timesofmoney.com, to enable policy-holders to make premium payments through the internet.

Pioneer ITI Plans To Launch A Gilt Scheme

Pioneer ITI Mutual Fund (earlier called Kothari Pioneer Mutual fund) will shortly launch a gilt scheme. The scheme will be open-ended and will invest only in government securities. The scheme will be segregated into three plans: Liquid Plan, Investment Plan and Specific Maturity Plan (SMP). While the Liquid Plan would give out monthly dividend and a growth option, the investment plan will offer quarterly dividend and growth option. The issue will be on par with a minimum investment requirement of Rs 5,000 and incremental investments of Rs 1,000. The scheme will give a further choice of three sub plans of different maturity periods under SMP, with a short-term plan that lasts up to six months, medium-term plan that lasts up to 13 months and long-term plan that lasts up to 25 months.