Debt is good but equity isn't bad

Debt is good but equity isn't bad

Rising interest rates and choppy stock markets are driving people to invest in debt.

There is an old saying: Gentlemen prefer bonds. But today, the one who is chasing a bond is a punter. The large hoardings and half-page ads screaming 9.5% interest on 370- and 490-day tenures are attractive and noticeable. It is more inviting every time the market tanks, but remember that equities give the highest returns over the long term and patience pays when invested in stocks. Gentlemen today prefer a mix of equities and bonds.

One big advantage of buying debt is that an investor can put together a debt ladder, a strategy favoured by evolved investors. They hold bonds with staggered maturities so that they have a portion of their portfolio maturing every year or two. This leads to a win-win situation. If interest rates dip, they still have bonds locked in at higher rates. And if interest rates rise, the proceeds of maturing bonds can be reinvested at higher rates. In a rising interest rate regime, you may get better rates every time an old bond matures to enter into a new one that offers you a higher return. This strategy works well only for active investors who can traverse from one investment to another without distorting their portfolios.

So, which debt instruments should one opt for? Small savings products (NSC, PPF) are no longer attractive. Bank deposits have dethroned them by offering similar tax benefits and higher returns.

However, in the short term, innovative mutual fund products especially fixed maturity plans (FMPs) are a step better than the pure debt products for the liquidity, safety and returns that that they offer (see box). An FMP is a mutual fund that invests in financial instruments whose maturity date coincides with a specific time period indicated in advance by the fund. For instance, an FMP of one-year duration will invest in instruments that mature in one year.

One big advantage of investing in FMPs is the tax efficiency they offer over fixed deposits—both in the short and long terms. Unlike the interest earned on bonds and fixed deposits, the income from investments in FMPs can be adjusted against the inflation rate during the holding period. This is especially useful at the fag end of the financial year, when investors can avail the benefit of “double indexation”. This advantage can be taken by investing in an FMP just prior to the end of a financial year and withdrawing it after the end of the next financial year. For instance, if you invest in an FMP in March 2007 and redeem the investment in April 2008, your profits will be adjusted against the inflation of two years. This way investors can reduce their tax liability (See table. For more details read MONEY TODAY 22 March 2007). It does not come as a surprise that today, 400-day FMPs are offered by a plethora of mutual fund houses.

However, the attractiveness of debt should not be construed as a signal to exit equities. At best, this is a time to take advantage of the current rise in debt. Bonds or bond funds provide stability to a portfolio. But you don’t have to park all your money into either equity or debt. Investing is not a binary decision. You need to look at both debt and equity. The key is asset allocation. Invest in bonds to bolster the debt component of your portfolio, especially if an upswing in the stock markets has increased the equity component. Of course, the proportion of investment in debt and equity depends on your risk profile.

For someone invested in equities, the current situation does not call for any wholesale realignment; at best one should look at reviewing the portfolio to get back and focus into large caps, the kind of companies you can easily understand and know of and have a proven track record. With the introduction of multi-manager mutual funds and fund of funds, the performance of equity mutual funds is likely to be more secure and steady. If you want to lock in for the long term for a specific purpose of growth and value creation, equities are still the instruments to stick with. If the volatile equity and commodity markets still unsettle you, shift some portion to debt to lend stability to your portfolio. But if you have the money and are in no hurry to spend it, equities are still the right place to be in over the next two years.

The author is CEO, Value Research