The Hindu Business Line : When `being' in debt is interesting

Stock market can be as exciting as watching a football match, especially when you catch it in a bull phase. Though it does not always remain euphoric. When the trend reverses and the market slips into a bearish phase, it can be nerve wracking. Exciting but scary! The scary part can be managed by debt investing.

Understanding debt

Debt instruments usually offer capital protection and, in addition, a fixed rate of return, if you hold them for a predetermined period (usually referred to as maturity). Investments in securities issued by Central and State governments, financial institutions, municipal corporations and public companies all come under debt investing.

While stock prices closely track earnings growth of companies, bond prices vary largely in accordance with changes in interest rates. Apart from interest rates, there are other variables such as tenure of the bond, redemption features, credit quality of the issuer, price and yield that need to be considered before making an investment. Let us begin with yield. Yield is the return you actually earn on the debt instrument based on the price you pay and the interest payment you receive. There are basically two types of yields: Current yield and yield-to-maturity. Current yield is the annual return on the amount paid for the instrument and is derived by dividing the instrument's interest payment by its prevailing purchase price.

Yield-to-maturity and yield-to-call are considered more meaningful as they indicate the total return you would earn by holding the debt instrument until maturity or is called back. They also enable you to do a comparison of debt instruments with different maturities and coupons (that is the interest rate).

Interest rates and bond prices

Interest rate is a key variable affecting the prices of bond instruments. Bond prices and interest rates are inversely related and move in opposite directions.

A rise in the interest rates leads to a fall in the prices of debt instruments, as fewer investors would like to buy instruments offering lower interest. As a result, the yield of older instruments is aligned with new instruments offering higher interest rates.

Conversely, when interest rates fall, the prices of outstanding debt instruments rise as more investors are willing to buy instruments that offer higher rates. As a result, the yield of older instruments declines until it matches the lower interest rate on new instruments.

There is a direct relationship between interest rates and maturity; longer maturity instruments usually carry higher interest rates.

This is because the longer it takes for a debt instrument to mature, the greater the risk that prices will fluctuate along the way. Investors would, thus, expect to be compensated for taking this extra risk.

Most debt instruments pay interest at a fixed rate for a fixed period of time. There are some that pay floating rates and few others pay the whole interest on maturity.

While investing in debt, the most important element to look for is the real rate of return, that is, the excess of nominal returns over the inflation rate; as only real returns add to the purchasing power.

Options

For those who wish to lend an element of stability to their portfolio, there are a slew of interesting options in the debt market which also offer decent real returns.

Over the long term, bank fixed deposits (FDs) offer attractive yields and also qualify for the Rs 1-lakh limit under Section 80C of the Income-Tax Act. They also ensure safety of capital as deposits up to Rs 1 lakh are insured. In the short-term, bank FDs are attractive in certain maturity brackets.

However, for shorter term options, mutual funds score over FDs owing to the former's greater tax-efficiency. Mutual fund dividends are tax-free in the hands of the investor, whereas the interest income from FDs is taxed at the appropriate slab rate.

Fixed Maturity Plans (FMPs) and floaters are best picks among mutual fund debt products. FMPs are close-ended funds with a fixed tenure and invest in a portfolio of debt products whose maturity coincides with that of the product.

Also, most FMPs are available for tenures ranging from three to 18 months and, as such, suit short-term investors.

Investing in floating rate funds also makes sense, especially in a rising interest scenario. As their rates are linked to the market rates, they would be in a better position to capitalise on the trend.

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.