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Rediff News  All News  » Business » Debt-funds can be an attractive alternative to fixed deposits

Debt-funds can be an attractive alternative to fixed deposits

September 01, 2014 16:05 IST

Bank FDs are thought of as the closest to risk-free returns for individuals, though these are technically guaranteed only until an upper limit of Rs 1,00,000 an individual, says Devangshu Datta.

Very few Indians see debt as an active investment avenue.

Very conservative investors never move beyond fixed deposit (FD) as an investment. More active investors regard this as a way to earn some interest on surplus funds, before putting the cash into more high-risk, high-return assets.

Debt funds aren't very popular and, after the last Budget removed a tax-arbitrage opportunity, these are likely to lose appeal further.

The lack of a deep, liquid secondary bond market also restricts options.

There are very few corporate bond issues and, in effect, these cannot be traded and must be held to maturity.

However, despite the downsides, it is worth calibrating debt investments to changes (or anticipated changes) in interest rates.

There are periods when debt can be quite profitable, as well as low-risk.

Typically, debt is reckoned low-risk or risk-free if return of principal is assured or very likely. But a debt instrument may give returns well below inflation and so, erode the value of the principal.

Bank FDs are thought of as the closest to risk-free returns for individuals, though these are technically guaranteed only until an upper limit of Rs 1,00,000 an individual.

Government Treasury Bills are the risk-free equivalent for institutions (individuals can buy T-Bills in theory, but it's very cumbersome in practice).

Any return must also be adjusted for inflation, or expected inflation. The real return from debt might be negative even when nominal interest rates are high.

Every return from every other class of financial assets can be compared to the FD as a proxy for risk-free return.

There is a subjective element attached, as for investments such as equity, we know neither the return nor the risk. Indian banks set market-determined commercial rates.

They offer the rates they think investors will find attractive and, of course, there is competition.

In practice, deposit rates tend to be within a fairly tight band and there is a tendency for interest rates to lag changes in inflation trends.

In general, if interest rates are falling, the value of a portfolio of existing loans (disbursed at higher rates) rises.

Conversely, if interest rates are rising, the value of a portfolio of loans (disbursed at lower rates) falls.

This trend is evident in T-Bill auctions. If interest rates rise, T-Bill yields also rise, as the price of the T-Bill falls. Conversely, yields fall and T-Bill prices rise if rates fall.

If the real interest rate is negative, the smart investor could be seeking avenues other than debt, where potentially higher returns might be available.

If the real interest rate is positive, money might flow into debt instruments. In the past year or so, we've seen the Reserve Bank of India (RBI) raise policy rates twice and, subsequently, maintain status quo.

Now, it appears inflation could be falling, at least the central bank hopes so. If inflation does drop, RBI is likely to start cutting policy rates in early 2015.

Banks will start to cut commercial rates only after RBI takes action. If the inflation trajectory is in line with RBI's targets, it will drop through 2015.

In that case, interest rates could also show a falling trend. If this scenario holds good, a strategy of buying into FDs with a timeframe of one-two years should be good.

By November-December 2014, the investor should also look at debt funds, which will see capital gains through 2015, if inflation keeps falling.

There are exact targets to look out for. RBI hopes for December 2015, the Consumer Price Index (CPI) will be no more than six per cent higher than the CPI for December this year, which in turn will be no more than eight per cent more than the CPI for December 2013.

As the December 2013 CPI was 138, the December 2014 and December 2015 levels should not exceed 149 and 158, respectively.

Devangshu Datta