Interest rates in India have come full circle in this decade. At the turn of the century, the economy was growing at a lazy 5.5 per cent. Demand for credit was low and interest rates were falling. Then, the Great Indian 8-per cent Growth Story started panning out, and industry went into overdrive.
Companies started expanding and making capital expenditures even as the retail population, you and I, went out and bought cars, homes, second cars and second homes. Most of this was fuelled by bank loans, which, of course, came cheap.
And then, the cycle turned. Even as our wallets brimmed over, inflation shot up. So, the Reserve Bank of India began taking steps to bring down inflation and prevent the economy from overheating. Its answer: raising interest rates. And, that really is how the story of this decade has unfolded - from optimism to celebration to caution.
For us as consumers, this means a story of 'plenty to just enough'; for us as investors, this means turning our investments in debt products on their head. In the first few years of the decade, as interest rates softened (reduced), debt funds were spectacular investment areas, but other debt investments, such as bank fixed deposits, were duds. Fixed income debt fund managers in mutual fund houses were actively managing the kind of paper they bought and their funds were delivering an average of 10 per cent returns on a relatively low risk base.
As interest rates fell, they were holding high interest paying bonds, whose prices rose. So the funds made capital gains. And, in 2001, some of the gilt funds paid returns as high as 30 per cent.
Now, of course, inflation rates have risen, times have changed and, with it, avenues have been created for debt investments. If you are still invested in fixed-income, long-term debt funds, your money is probably earning nothing. In fact, your inflation-adjusted returns are likely to be negative. And suddenly, products like bank fixed deposits and fixed maturity plans have regained their sheen.
There is one issue that needs to be tackled before we go further. The stockmarket is at its volatile worst. It has come off its highest levels, but no one is considering that a blot on the long-term optimism of our economy. The question many are asking is, in this scenario, should you still invest in equities, or should you play it safe and invest in the high-return fixed deposits that sound unimaginably attractive at 10 per cent? This is the wrong question. It is certainly not an 'either-or' issue when it comes to equity and debt. In your portfolio, you need to allocate your assets to both.
The question that you should be asking is whether you should rebalance your debt. By that, we mean not only your your borrowings, or liabilities, but also investments, or assets. And the answer to that is a resounding yes.
Debt, in fact, is a double-edged sword. While times like these imply higher yielding debt instruments, they also mean paying a much higher rate of interest on the loans you have taken. Balancing the two is the key to managing your portfolio. Look at Rituraj Mehrotra. He took a hefty home loan about four months back at 9 per cent floating rate.
"The interest rate has been on the rise since then," he says. It went up from 9 to 9.5 to 10 to 10.5 and, then, to 11 per cent. "I found that the interest on home loans was 3 per cent in the US, 4-5 per cent in Singapore and 0.25 per cent in Japan. I thought the interest rate in India would also come down sometime soon. But, it has been the reverse here."
Mehrotra has also invested in fixed deposits, stocks and life insurance. He had invested in two FDs at 10 per cent return with ABN Amro Bank about eight months back. But, on 18 April, he broke the deposits to pre-pay a part of his home loan, which had swelled because of the hike in rates. So, while Mehrotra has a happy story to report as an investor, his calculations have gone awry as a consumer of debt.
Being a smart investor and borrower, he figured out that the post-tax, post-inflation return his 10 per cent FD would fetch would be around 1 per cent, while the effective cost of his housing loan after accounting for tax breaks would still be significantly higher at 7 per cent-plus.
In the following paras, we look at various kinds of debt assets and liabilities and calculate their returns and costs after accounting for taxes and inflation. Comparing them should make the task of rebalancing your debt a pretty easy one. Just remember, a penny saved is a penny earned. So, here are five strategies that should deliver the goods for you.
Although rising interest rates have made most debt funds unattractive (interest rates and prices of debt securities move in opposite directions), you could still make money from two classes of debt funds: fixed maturity plans and liquid funds.