Playing on debt

Over the last few years, with equities unable to carry on with their dream run, investors turned to other asset classes, such as debt and gold, the latter as a hedge against inflation, in search of returns.

Investors who invested in debt products, especially the ones who entered into duration products in mutual funds or directly into debentures and bonds, have benefited from the dovish policy stance adopted by the RBI from October 2011 to May 2013 (The repo rate fell from over 8 to 7.25 per cent), with returns on many bonds touching double digits.

Rough ride After June 2013, it has been a rough ride for the investors as they have seen unprecedented volatility which is uncharacteristic of the fixed income markets, due to the turn in global events.

The RBI, in a bid to curtail volatility in the currency markets, initiated unprecedented liquidity tightening measures during this period. This resulted in debt markets turning volatile with yields spiking up across maturities.

The shorter end of the yield curve saw yields going up 300 to 400 basis points, handing down temporary mark-to-market losses and denting the perception of fixed income markets being a source of stable returns.

Tight measures by RBI Over the last few months, the RBI has taken steps to cautiously unwind some of the exceptional tightening measures undertaken in July 2013. With the macro environment improving, the market expects the central bank to hike rate once more this financial year -- this time by 25 bps in the repo rate.

We believe that the RBI is done with its rate hikes at the moment and will look to pause with an eye on the overall macro picture, including the US Fed stance on tapering and the resolution of US debt ceiling limit by February 2014.

So, before you jump in and invest your hard earned money into debt products, you need to keep a few things in mind. Here’s a short list.

Expenses A debt security, by nature, generally accrues a coupon on the capital invested as the primary source of return for the investor. Therefore, it is important that one knows the expenses being charged on the product as a higher expense would eat into the potential returns. You also need to watch out for the credit rating of the product or the underlying instruments it invests in.

Higher returns would mean the product probably has higher exposure to lower-rated instruments.

Similarly, a higher rating of the product or underlying instruments mean a lower probability of default or downgrade and consequently lower return from the investment.

Taxes Most bond offers, except tax-free bonds, pay tax at the slab rate on interest earned.

The advantage of debt mutual funds is that they are tax-efficient investment vehicles.

An investor can look to lower his tax payout by claiming indexation benefit for investments made for more than one year in debt mutual funds.

Be it fixed deposits, bonds, debentures or debt mutual funds (such as fixed maturity plans; lower duration such as ultra short term funds and short term category of funds) the market continues to offer investors the opportunity to gain from elevated returns across maturities despite the volatility shown over the last few months.

So invest in debt funds based on the 4Ps: Investment Philosophy, Products, Portfolios and Performance.

(The author is Head of Fixed Income, UTI MF)

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