OTHER RELATED STORIES

Down But Not Out

Taxing Time

Everyone seems to be rocking in tandem with the gyrations of the BSE Sensex. Given all the hoopla surrounding the stock market, it would appear correct to assume that India is a nation of equity investors, but the truth is far from that. A major chunk of the lay investor's money is still directed to traditional savings tools, also called debt instruments, such as savings bank accounts, fixed deposits (FDs), Public Provident Fund (PPF), post office savings schemes and, of course, debt funds. Debt funds performed well in the past only because of the drop in interest rates all these years. So while investors counted them as returns from the funds, it was actually the external rate environment that did the trick. Now, however, interest rates are showing signs of hardening in the short term. Says Subir Gokarn, Chief Economist, CRISIL: "While it's too early to take a long-term call on interest rates, we expect the short-term rates to harden to 7 per cent (from the current 6.75 per cent)." Therefore, this has precipitated a re-think of debt fund strategy.

As far as independent investors are concerned, till a few years back, you didn't really require a strategy for debt investments. Simply because interest rates were on the higher side and inflation was low, ensuring reasonably high returns. And though inflation is still at a relatively low 5.6 per cent today, the era of high interest rates is over. So today if you think of, say, just a bank FD as a viable savings avenue, you'll come a cropper. The interest that you get from such an instrument averages 7-odd per cent, just 1.4 per cent higher than the inflation rate, leaving you with money that has appreciated in absolute terms, but has not quite given you the returns that you desire.

What all this means is that debt investing is not a handed-down-through-the-generations wisdom any more. It needs a proper, well-defined strategy, which includes picking the right products and in the right proportion. Says Deepak Sharma, Head of Distribution, IL&Fs Investsmart: "Need-based investment planning and an asset allocation exercise would be as important to a debt investor today as an equity investor." This is particularly important in order to avoid any opportunity loss (meaning you lose out on higher returns that you could have gained from somewhere else, such as equity), as Sandesh Kirkire, Chief Investment Officer (Debt Segment), Kotak Mutual Fund, points out: "While you don't ever lose money permanently in debt markets (unless there is a credit default), as there is a coupon rate attached to every instrument that supports it, an opportunity loss could happen as a result of duration mismatch." Which is what happened in the six-month period between May 2004 and December 2004, when debt funds reported negative returns.

And if you're one of those hardened types who are suspicious of new debt products, that's something you need to change because you can no longer rely on just one type of debt product if you want your money to grow in real terms. Now that you have the overall picture, let's check out what's available and what's advisable.

Short-term Avenues

If you are looking for quick fixes, here are a couple of options:

Short-term Deposits: Sweeping a part of one's salary to an FD account is a common savings strategy, but is not a great idea. That's because bank deposits-savings, recurring and short-term deposits-have a very unattractive rate of return. As such, a small portion of your portfolio could be allocated to this debt avenue only to serve as a short-term measure for quick money (in case of medical emergencies, for instance). You could also opt for a short-term deposit (with interest rate at around 4-6 per cent) with monthly or quarterly rollover instead of parking money in a savings account at 3-odd per cent interest per annum.

Short-term Funds: Alternatively, you could go in for short-term funds, which come in two colours. One, short-term plans that invest in a combination of debt paper with shorter maturity and cash/call money, typically meant for investors with a time horizon of three months-plus. Two, liquid funds that invest in shorter-term instruments, meant for investors with a time horizon of one month. What's special about these? Explains Kirkire: "In short-term funds, the active portfolio (cash) management is critical in volatile market conditions to help produce marginal returns despite markets giving negative returns." The added advantage is that since these papers mature early, volatile interest rates have less of an impact on their returns.

Long-term Avenues

If, however, you're looking at the long haul, here are some choices for you to chew over:

Bonds: Infrastructure and other government bonds are useful in the sense that they give you tax breaks, and could form 5-7 per cent of your portfolio.

Public Provident Fund (PPF): One of the most popular debt instruments going around, the PPF could eventually make an exit, although that may not be very soon. It would, therefore, be prudent to make the most of it while it lasts. Though illiquid (read: you can't withdraw any money) for the first seven years, you can do so in parts thereafter. What clinches the argument in PPF's favour is that it is an effective retirement planning tool (yielding around 11.5 per cent returns per annum), particularly for those individuals who don't have access to a regular (company-backed) pf scheme.

Postal Savings: Another popular option, post office schemes include the National Savings Certificate (NSC) and the Kisan Vikas Patra (KVP). While KVP doubles your money in eight years and seven months (yielding 8.46 per cent interest, among the highest offered by debt instruments), it does not offer tax breaks like the NSC, which also provides reasonable returns (8 per cent). So if you're desperately looking for a last-minute tax-saver, NSC is a good option, but be prepared for a long haul to get back your money, since redemption happens six years later.

Long-term Deposits: Even though these are preferred by a large section of debt investors, they add to your tax burden since the interest earned is taxed, unlike most others that come under the purview of Section 80L of the Income Tax Act (see Taxing Time later in this section). If you are still looking for long-term money-parking avenues, you could consider income funds.

Income Funds: Also called long-term debt funds, these are what you should be looking at for the long term, and for the long-term only. Says Kirkire: "The kind of horizon one is looking at, especially for long-term debt funds, has to be clear. If you are investing for (a period of) less than one year, an income fund is surely not the right product." Why? Although these funds give returns in excess of your regular long-term deposits, and are tax-free to boot, they could ail over a volatile short-term period (such as during May-December 2004) due to a duration mismatch. So if you have money that you want to invest for a period that is between a year and three years, income funds are your best bet.

Floating Rate Funds: If you're looking for an element of stability in your debt portfolio, floating or flexible rate funds provide you with just that. Says Sharma of IL&Fs Investsmart: "Floating rate fund is a great bet as it is a guard against any rise or fall (volatility) in interest rates." This it does through a low-risk strategy of investing in good quality floating rate debt or money market instruments, or fixed rate debt or money market instruments swapped for floating returns, ensuring stable and secure returns in the bargain.

At this point in time, when interest rates are poised to harden, short-term funds are a better bet, and it would be a good idea to keep income fund investments on the lower side. So an ideal balance in your debt portfolio would be: 15-20 per cent bank deposits (all kinds), 20-25 per cent PPF, 10-15 per cent postal savings, 5 per cent bonds, and up to 35 per cent in a combination of short-term and long-term funds. Need we say more?