Most Indian investors think of debt as a balancing figure in asset allocation. They spend a lot of time and effort on choosing and timing equities while debt investments simply get residual money without much active management. But with Indian markets offering healthy yields, debt investing can make a strong contribution to your wealth creation plans.
Investors who parked all their money in 10-year Government of India bonds in the last 15 years have made a 7.4 per cent CAGR (compounded annual growth rate) while the total return on the Nifty 50 was 9.4 per cent. In this period, the 10-year government bond, the safest investment in the market, has given multiple opportunities to lock into yields of 8 per cent for a decade. But taking advantage of opportunities in the debt market calls for an active strategy on the following lines.
Track rate cycles
Most investors think of interest rates as being on a secular decline. But the line graph of the 10-year government bond, the debt market bellwether, resembles a roller-coaster more than a slide. In twenty years, Indian interest rates have seen four up-down-and-up cycles. In the first cycle, the 10-year yield, which ruled above 10 per cent in March 2001, fell to 5.1 per cent by October 2003 before getting back to 9.3 per cent by July 2008. In the second, the yield slipped to 5.2 per cent by December 2008, before reviving to over 9 per cent in November 2013. The third cycle took shape when yields receded to 6.2 per cent in November 2016 before regaining 8 per cent by September 2018. We are currently in the fourth rate cycle where yields have rebounded from the Covid lows of 5.8 per cent in December 2020 to over 7.4 per cent now.
Going by history, a complete rate cycle from top to bottom and back again in India has lasted between five and seven years. A 5 to 5.5 per cent yield on the 10-year g-sec has usually marked the bottom of a rate cycle, while 8-9 per cent have signalled the tops. Knowing these ranges helps you gauge where we are in the rate cycle. Today, with 10-year yields at 7.4 per cent, the upside to yields (downside to bond prices) appears limited. Once you have a fair understanding where rates stand, active debt investing decisions become easier.
Sophisticated global investors also use the yield gap to decide between equities and debt. In India, we can compare the yield on the 10-year g-sec with the earnings yield on the Nifty50 (inverse of PE ratio). The average yield on the 10-year g-sec has been at roughly 1.4 times the Nifty50 yield in the last 20 years. Today the 10-year g-sec offers 1.7 times the Nifty yield, making this a good time to invest in bonds.
You can make very healthy debt returns from safe investments by making the right duration calls — decisions on whether you should lock into long-term debt or stick with short-term options. Investors who bought into the crop of 15-year tax-free bonds from public sector issuers such as NHAI, REC and HUDCO in 2012-13 have not only pocketed high coupons of 7.5-8.5 per cent for the last 10 years but are also sitting on capital gains from the decline in interest rates.
But while such opportunities come once in a lifetime, you can make good debt returns even without getting your timing or duration exactly right. Broadly, when market yields are at 5-6 per cent, you can allocate more to less-than-one-year bank FDs, NBFC FDs, treasury bills and post office schemes and low/short duration debt funds. When yields get to the 7.5-8 per cent range, switch to 5-year-plus options. Though options such as NCDs and g-secs do exist for 5 year-plus tenures, debt mutual funds today offer the most tax-efficient route to benefitting from duration. Constant maturity debt funds, which mimic the 5-year or 10-year g-sec, target maturity funds that invest in State Development Loans and gilts help you lock into high yields, with handsome indexation benefits on your final returns.
Taking credit calls
Taking duration calls on safe debt is one way to earn higher returns. The other is investing in lower-rated companies for a higher yield.
The IL&FS, DHFL and Franklin Templeton episodes tell us that shooting for high yield in the Indian debt market can saddle you with big losses or liquidity risks if you get it wrong. Retail investors may need to keep three things in mind while adding riskier credit. One, the bond market in India is a fair-weather animal. When the economic cycle is upbeat and liquidity is ample, riskier bonds and FDs deliver returns without a glitch. But when there’s global or local market turbulence or an economic downcycle, liquidity in lower-rated bonds dries up quickly. Therefore, credit calls are best taken when liquidity is normal and the economy is upbeat.
Two, investing in below-AAA entities involves not just credit risk but liquidity risk. The yields you earn need to compensate for both risks. This makes it critical to look for high spreads (extra returns) on bonds or FDs of lower-rated entities compared to prevailing g-sec yields. Three, the Indian bond market is far more opaque than the equity market. Taking credit calls often means taking a qualitative call on a company’s promoters and governance. Retail investors are therefore better off using credit risk mutual funds over individual bonds or FDs, so that diversification can take care of default risks.
Have a wider menu
To maximise your debt returns, the ability to switch between different options is essential. During Covid, small savings schemes offered better returns than FDs or bonds. In the post-Covid world, g-secs have been the fastest to adjust to rising yields. As economic conditions stabilise, AA-rated corporate bonds will be back in the picture. Ensuring that you have access to this entire menu of options is critical to an active strategy on debt. If you don’t have access to g-secs or privately placed corporate bonds, do explore opening accounts with the RBI Retail Direct Gilt platform and regulated retail bond platforms, so that you can cherry-pick your debt.