Increase allocations to short term debt funds and keep an eye on credit risk, in choosing between debt options.

Aarati Krishnan

Interest rates have climbed steeply and may rise further. Credit is getting tighter as RBI attempts to soak up excess liquidity, in its bid to cool inflation. Lenders are becoming more wary about credit risk and are looking to curtail lending to vulnerable sectors. As a debt market investor, each of these trends has relevance to you, as it might call for a review of your debt portfolio. Here’s how:

Go for the short term: Interest rates on short-term bonds have been pushed above those for long-term bonds, thanks to rising policy rates and tight liquidity. The yield on one-year government bonds now hovers at 9.35 per cent, against 9.25 per cent for the 10-year bond. This means that short-term debt instruments now offer better returns, with lower risk, than long-term instruments.

Also, long-dated bonds are more vulnerable to declines in price due to rising interest rates, than short term bonds. All this is reason for debt investors to stay away from long-term debt funds (which may face NAV erosion if bond prices fall further) and invest in short-term debt funds (average maturity of one year).

Liquid funds, short term income plans and ultra short term income plans fit the bill well. These funds are also best placed to take advantage of opportunities arising from tightening liquidity conditions in the debt market. Returns on liquid funds over the past year have been in the 8-9 per cent range. The pedigree of the fund house and the expense ratio should be the key factors you use to choose between liquid funds.

FMPs or liquid funds? Attractive investment opportunities in the bond market have prompted many fund houses to roll out Fixed Maturity Plans (FMPs) with terms ranging from one month to one year-plus. Though longer-term FMPs with 3- and 5-year terms also exist, they usually carry some allocation to equity, that raises their risk profile.

The key advantage of FMPs over open end options (such as liquid or short term bond funds) is their higher yield and the ability to deliver a predictable return for a fixed term, without taking a call on how interest rates will move. Returns from liquid funds or short term bond funds may fluctuate or even decline if short term interest rates ease off; but if you have locked into a one-year FMP, it will still provide the return indicated at the time of the offer.

However, the key disadvantages with FMPs lie in their lack of transparency (portfolio disclosures are more frequent with open end funds), lock-in feature and the short windows (usually 2-3 days) for which they are open. Locking into an FMP effectively robs you of the flexibility to redeem your investments at will. Also, you may be unable to ‘reset’ your interest rates higher, should market interest rates tread up further. Templeton Fixed Horizon Series IX, ICICI Pru FMP Series 46, Sundaram FTP –J are some of the FMPs currently open for subscription and their indicative yields fall in the 10-11 per cent range.

Factor in credit risk: Finally, the warning note on credit risk, sounded by the central bank in its recent policy review, should also be noted by investors while sifting between debt options. A tighter macro environment for business now, signals that companies in capital intensive or cyclical businesses may face pressure on their debt servicing ability, amid climbing interest rates.

In the months ahead, this may throw up many opportunities to invest in high-yielding debt issued by entities facing a funds constraint (for instance, companies that enjoy lower credit ratings and from sectors such as realty).

However, chasing a high yield may entail a sacrifice on the credit quality of the debt instrument, putting the investors’ capital at risk. Investors need to tread with caution on debt funds offering exceptionally high returns, for much the same reason.

(This article was published in the Business Line print edition dated August 3, 2008)
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