Explores the risk and reward related to various fixed rate instruments

In the current situation when the equity markets have lost their sheen, the activity in the debt instruments is expected to catch up. Karan Sehgal explores the risk and reward related to various fixed rate instruments

TILL January 2008 equity markets were buzzing with activity and the Sensex was scaling new heights every passing day. And, till that time, we rarely came across anyone talking about investments that yielded a fixed albeit, a tad lesser return than the equity markets were offering. Now that the returns from equity markets are in doldrums, the fixed rate instruments are seeing a revival. However, toward the end of 2008, the money market was so volatile that the fixed maturity plans (FMPs) saw unprecedented redemption pressures and at the same time banks began to offer term deposits with interest rate as high 11% per annum (p.a.). Obviously, the retail investor is right now confused as equities are still on a downtrend and fixed rate instruments, too, have been volatile. We at ET Intelligence Group think that it is a pertinent time to provide our readers with insights on various fixed rate instruments.
    Indian money markets saw tightening liquidity in October '08, which resulted in banks offering high interest rates on FD. Soon, Reserve Bank of India (RBI) stepped in to ease rates; therefore the banks had to cut the interest rates on FD by few basis points. Still, large banks are offering FD with 9% interest p.a. At the same time, the inflation has come down from the peak of 12.6% in August '08 to just 3.03% as of now. Today, the real return on bank's FD is much higher than any time in recent years.
    With falling inflation and interest rates, the return on bank's FD is also expected to come down. Therefore, it makes sense for investors to park some cash in FD as banks might cut down rates in near future. While raising money in equity markets seems dicey, more companies are expected to raise money from retail investors, the way Tata Capital did. Investors should keep an eye on such public issues as they are expected to provide either better return than bank FDs or at least at par.
    Apart from these options, we also have liquid fund, debt fund, gilt fund and FMP. Though all these instruments invest in fixed rate securities, it is important for investors to understand the underlying risk. Liquid funds, as the name suggests, invests in short term paper, typically, of less than one year term like short term commercial papers, certificates of deposit and floating rate bonds. The credit risk is low. There is a brief lock-in period and if an investor redeems before the lock-in period expires, there is an exit load. Such funds are considered to be the safest bet due to low credit risk and high liquidity. An investor should consider exposure to liquid funds in case his money is lying idle in the savings bank account.
    On the other hand, debt funds invest in longer term paper issued by companies, central and state government. These funds are open ended. As the paper is of longer term, the variations in its value with respect to changes in interest rates are also high. This makes these funds risky compared to liquid funds. Therefore, an investor should consider exposure of at least six months or more. It comes with dividend and growth options. Now that the RBI has reduced the key interest rates, many debt funds have increased the maturities of the investments. So, it makes more sense for the investor to opt for dividend option because the longer term paper will take huge hit if interest rate rises.
    Gilt funds offer investment products for various maturities ranging from few months to several years. These funds too are open ended in nature and are exposed to market risk. Therefore, it makes sense for an investor to opt for short-term gilt fund when he/she has clear idea about the direction interest rates will take. Such funds can yield high return on a long-term basis, when the yields come full circle and volatility evens out. The yield on one-year government security (g-sec) has come down from 8-9% last year to 5.3% now, which has pushed up the prices of g-sec. This helped gilt funds in making a killing. As of now, the yield on g-sec has come down sharply and further gains in prices are expected to be modest. It makes more sense for the investor to go for debt mutual funds as they have exposure to corporate bonds also, wherein the interest rates have not come down as sharply as in the case of g-sec. Of late, FMPs have become a subject of controversy. FMPs are close-ended funds, where in the fund manager invests money based on the maturity for which the investors are providing him funds. In case, the investor wants to exit early, a high exit load was levied. However, SEBI has prohibited the early exit from FMPs as they faced huge redemption pressures in late 2008. As per SEBI's latest order, FMPs are required to be listed on stock exchange so that investors can exit the fund by selling it in the secondary market. The spate of regulatory intervention has resulted in a virtual halt of activity in the FMP space.
    On a short term basis, equities are unlikely to see a revival. Debt funds can provide higher return to investors, as interest rates are on downward trend. It is very difficult to forecast debt or equity's performance over the long term. However, today an investor has more options in form of a liquid funds, debt funds and gilt funds. But one must understand that these products are not like FDs, where return is assured. The returns on such products can be very high or in fact can be negative. The past performances of such funds do indicate that a certain portion of investment must find its place in such instruments. The investors must invest a fixed percentage of their yearly investment corpus in bank FD and public provident fund (PPF) schemes as they come with absolutely zero risk. Even when the equity market is booming, investments in FD and PPF should be made.
    karan.sehgal@timesgroup.com