Consumer inflation measured by consumer price index (CPI) has averaged 10.43 per cent in the last fiscal. The chronically high inflation in recent years has pushed down real interest rates to negative territory.

Through the course of 2012-13, real rates were mostly negative, which reduces the incentive for Indian consumers to save.

The higher tax rate on deposits is a further spoiler for depositors. Debt funds offer higher effective returns than fixed deposits, given their flexibility to play interest rate movements, while generating more tax-efficient returns.

Most debt market instruments work on the principle that falling yields will result in rising prices and vice-versa. Hence, the best time to invest in a long duration debt portfolio is when the RBI begins to reduce rates to stimulate growth; interest rates will fall across the board.

This will result in bond prices appreciating, resulting in capital gains.

Match your horizon

Investors must choose the debt fund that best suits their investment time horizon.

Liquid funds are suitable for a very short-term horizon of one week to three months, while income funds can be chosen for slightly longer terms of 12 to 24 months.

Investors can look to invest in Fixed Maturity Plans when they have their investment horizon defined.

Debt-related volatility is high in dynamic bond funds, gilt funds and income funds. The prices of these instruments fall with a rise in rates and rise with a fall in interest rates.

As the RBI is now poised to cut rates progressively in 2013 to stimulate growth, prices of these instruments are bound to increase.

As the volatility is high in these instruments, returns are also high. So if you can take a little risk, you can earn higher returns than traditional bank deposits.

However, keep in mind your investment time horizon, liquidity needs, and overall returns. In the current economic scenario, market expectations are for a 50 basis point rate cut in 2013-14.

Thus the current high interest rate regime is expected to change next year. This appears the best time for investors to re-visit their fixed income investments.

On bank deposit rates, we feel the emerging credit deposit equation will play a vital role in deciding the direction of interest rates.

In the longer term, we feel that the pick-up in economic activity will give more comfort to markets, as it will improve the fiscal situation and will also force banks to raise more deposits to fund the credit offtake which, in turn, will create additional demand for government securities.

Also, short-term certificate of deposit (CD) rates can move southwards because of lack of more supply at the start of the new financial year.

The return on the liquid funds will follow the movement in the CD yields.

Investors can time their entry into long duration funds as confidence in the economy emerges. The fiscal deficit and RBI action will be key factors to watch.

Till such time, investors can look at the short-term bond funds, where they can keep earning healthy returns with limited interest rate risk.

(The author is Fund Manager – Fixed Income, Mirae Asset Global Investments.)

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