29 May, 2012

Build a great Fixed Income portfolio to tide over the uncertainties

Inflation is killing as it has been at high levels for over three years now. Stocks markets have gone nowhere in this period, with the possibility of a slide down the slope, due to worsening fundamentals in the Indian economy  and the adverse effects of the debt overhang in Europe and the not-too-good position in the US.
Investors have got tired of waiting for returns in equities. Some have commented to me that they would have been better off investing in fixed deposits itself, rather than equities. 

While that looks fine on the surface, equities tend to perform over the long-term. Now, there is debate on what constitutes long-term.  The normal definition of 3-5 years is being questioned, as in the past 5 years too, equities are showing negative returns. We are in uncertain times now.  For those who want to play safe, this is indeed a good time – for the interest available for fixed income instruments have peaked and there are quite a few viable options for constructing a fixed income portfolio.

1.       Fixed Maturity Plans ( FMPs )-  FMPs with one to three year durations are available from Mutual Fund companies which offer between 9-9.5% returns. That may not look like much. But the tax treatment for FMPs are benign. For a period  beyond one year, capital gains need to be calculated and taxes applied. Capital gains taxes beyond one year is 10% without indexation and 20% with indexation. Due to this, the net returns are estimated to be between 8.8% - 9.2%. Now that is not bad, is it?  Also, the instruments into which FMPs invest have maturities that more or less coincide with the tenure of the FMP.  This would ensure that there is no scope for variability in the returns and would get the coupon rates of the underlying instruments, irrespective of any changes in the interest rate cycle in the interim.

2.       Debt Funds – Debt funds are probably very good instruments in the fixed income space as they offer coupon rates of the underlying instruments as well as the potential for capital appreciation. When interest rates start moving down in the system, the underlying instruments which would have coupons higher than the prevailing rate, would rise in value. This would mean an increase in the NAV of debt funds, which hold such instruments. Hence these debt funds have the potential to offer double digit post-tax returns, in a falling interest rate scenario. The funds which hold comparatively longer tenures could offer higher capital appreciation, in a falling interest rate scenario.

But then, there are different kinds of debt funds. Some of them are dynamically managed funds, where the duration and the instruments are decided by the fund manager. In such funds, the fund manager keeps moving in and out of various instruments and manages the fund based on the unfolding situation. Some of the funds follow a clear buy and hold strategy as well. Funds which hold gilts could be volatile, but also have maximum potential to offer returns in a falling interest  rate scenario.

3.       Short tenure Debt Funds - Those looking at about one year could look at funds that invest in Ultra short term funds & short term funds. The nomenclature is a bit fuzzy here. Depending on the tenure these may invest in corporate bonds, Certificate of deposits ( CDs) of upto one year tenure ( CDs of one year tenure  are today yielding about 10% now ) & Commercial Paper of short tenures.  These funds can yield attractive returns, even over short periods of less than one year.  

Shorter tenure funds, with tenures of less than one year are designated ultra short-term funds. Such funds typically invest in instruments of very short tenures only. Since  3-month CD is offering  9.85% and 3 month Commercial Paper is offering 10.15%, ultra short-term funds would be able to offer attractive returns today.  The best option to choose would be dividend, as the dividend distribution tax here is 13.5%, whereas the tax would be as per the tax-slab if Growth option is opted for. Hence, Ultra short-term fund would be an excellent place to park short-term money, given that short-term bank FDs would offer 5-6% pretax return and SB account would offer 4-6% pretax return.
4.       Fixed deposits – This is a favorite among people who want to play safe with their money. Bank fixed deposits is a vehicle of choice among the public, primarily due to the low risk associated with it.  A one to three year deposit today is offering 9-10% returns today pretax. There are also company fixed deposits which could offer upto 1-2% more. But they are somewhat higher on the risk measure and the investor is advised to look at the rating assigned to the offering before investing. Triple A indicates highest level of safety and AA+ indicates a very good level of safety for return of principal and for receiving interest.

5.       PPF – PPF has traditionally been an attractive vehicle for investment, as it offers tax-free returns, which currently stands at a whopping 8.8%! Though PPF is a long-term instrument and liquidity is constrained, it has it’s set of followers and with good reason. One can invest upto Rs.1 Lakh in an account per year, which offers good savings potential for the family.

6.       Bonds – Tax free bonds which came up last year, was a hit with the public. They were again long-tenure instruments of 10-15 years, which had yields of  8.2-8.3%. These are attractive yields over the long-term. In a sense, it is even better than PPF, as these returns are assured over 10-15 years. PPF returns can change year-on-year and can go much lower than 8.8%, at present.  Even those who have missed the bus then can buy from the bourses, at an yield of about 8% now. That still presents an attractive opportunity.

In sum, there are many attractive fixed income instruments available at this time. The portfolio can be constructed using these instruments according to the specific requirements of the investor.  There is also the comfort that this is going to yield a decent positive return, irrespective of what happens to our stock markets, our economy and the global economy. 

Published in Business Standard on 27/5/2012;  Author : Suresh Sadagopan, www.ladder7.co.in