Personal finance revolves around asset allocation. Mix the right assets in the right proportion, and take diversified exposure in each asset class. Over the long term, this should fetch acceptable returns for acceptable risks.
It’s assumed that equity should, in the long run, deliver higher returns than other financial instruments and that compensates for the stock market’s extra volatility. It is also assumed that debt is safer, more stable than equity, hedges against a bad bear market, and offers fixed returns.
Fallacious assumptions
Is that second assumption about the nature of debt true? If a corporate chooses to default on a loan in India, legal recovery is very slow. In effect, Indian non-government debt is not as secure as is presumed.
In theoretical terms, real debt returns depend on inflation and currency stability. Both are volatile variables. Over the past 10 years inflation in India has ranged between 2 per cent and 13-14 per cent. Currency value has also swung a lot. So you don’t have assured real returns in debt.
If you are investing in debt across time frames and instruments, the only reasonable method is via debt mutual funds. Debt mutual portfolios are marked-to-market and inversely correlated with rate movements. If rates rise, a debt fund’s NAV drops. So there may not be even assured nominal returns if rates rise sharply. Such trends can occur over long periods.
So while the basic principles of asset allocation are sound, specific assumptions about safety and return need modification in an imperfect economy like India. Debt in India is more risky than is generally assumed, though admittedly safer than equity.
Many investors also see debt as a hedge against falling equity. But this is a fallacy, as pointed out above. Equity valuations usually fall if interest rates rise. But so does the value of debt. Both debt and equity give positive returns when interest rates fall. So there are long periods when debt and equity returns travel in the same direction. So the counter-cyclical hedging power of debt is limited.
Hence, higher equity weights may be sensible in an Indian environment because debt is relatively more risky than in First World economies. Of course, some allocation to debt is mandatory for any prudent individual.
The way out
But most investors should be willing to take higher equity exposures. One method of dynamic rebalancing could be to use the spread between earnings yield (the inverse of the PE ratio or Earnings/Price as a percentage) and the interest rate yield. Using a one-year fixed deposit rate or a 364-Day Treasury Bill Yield as the interest benchmark, we can compare it to the EP ratio.
A simple allocation rule would be: “If EP ratio is higher than T-Bill Yield, increase equity allocations. If EP ratio is lower than T-Bill yield, increase debt allocation.” This simple rule has worked well through the past decade or so.
It can be smoothed with checks on overall rate trends, and the differential amount. If the differential is large, signals are stronger. Historically since 2000, anybody who has gone overweight in equity in a disciplined fashion when the spread offers buy signals has made excess returns.
Several periods stand out. Between December 2002 and December 2005, the signal was continuously positive while the Nifty gained 200 per cent. Between October 2008 and January 2010, the signal was positive again while the market travelled up 72 per cent. Equally important, it kept equity allocations low during the big bear market of February 2000 to December 2003, when the index lost 40 per cent and again in the bear market of December 2007 to October 2008, as the market lost 60 per cent.
The 364-Day T-Bill seems like a good proxy for long-term returns. It is auctioned twice in the normal month, so there is a continuous flow of regular data points. T-Bill movements anticipate changes in fixed deposit rates. While these instruments are traded far more often by institutions than by individuals, they can be held by individuals. Of course, anyone building a PF portfolio could back-test other debt instruments and timeframes and may find more suitable benchmarks.
The basic point is that the individual should be aware that asset allocation cannot be done blindly following US-centric models. In a developing economy like India, debt is more dangerous than most people assume and the push towards equity should therefore be stronger.
source:valueresearchonline.com
Friday, September 24, 2010
Friday, September 17, 2010
Higher rates can adversely impact your fixed-income savings
BANKS are quick to lower fixed deposit (FD) rates when the interest rates fall, but they take their own sweet time to raise rates when the interest rates rise.
How many times have you heard this refrain from someone, especially a retired aunt or an uncle, in the recent past? With living expenses soaring each day, most investors, especially those who swear by FDs and other relatively safer avenues like company deposits and mutual fund (MF) schemes, are in a fix. The expenses may mount, but their interest income remains steady.
They also have to worry about their investments in debt mutual funds, as a rising interest rate regime is bad news for these schemes.
INTEREST RATE SCENARIO
The Reserve Bank of India (RBI) has started raising the policy rate since February in its effort to contain inflation. It has increased the repo rate (the rate at which it lends to banks) by 1.25%, reverse repo rate (rate it pays to banks) by 1% and cash reserve ratio (the percentage of deposits banks have to keep with RBI) by 1% this calendar year to check easy liquidity.
According to investment experts, the banking regulator is likely to raise rates further. “We expect a 50-basis point increase in policy rates in the near future,” says Nandkumar Surti, chief investment officer, JP Morgan AMC. This means, interest rates — the key variable to watch out for a fixed income investor — are surely north-bound, at least, in the short term.
What do you do in such a scenario? Consider this: you can’t lock the money in long tenure FDs because you can’t take advantage of rising interest rates.
Also, you have to be very careful while investing in MF debt schemes because of the inverse relationship between the price and yield of securities. So, it is crucial that you pick instruments that match your investment horizon and risk appetite.
SHORT-TERM INVESTMENTS
If you are looking to park your money for less than a fortnight, choose a liquid fund.
The liquid-plus option is more suitable for an investment horizon of more than a fortnight. These funds can give better tax-adjusted returns than saving bank accounts. However, don’t treat these funds as investment avenues.
They are meant for parking money temporarily. For short-term investments of three months to a year, you should consider short-term bond funds.
Before investing, take a look at exit loads charged by the schemes, if any, as exit loads erode returns.
MEDIUM-TERM NEEDS
You can consider company deposits and Fixed Maturity Plans for your medium term investment needs. Company deposits pay a little better than bank FDs, but they are more risky. Always look at the credit rating of the company and don’t invest more than 10% of your debt portfolio in a single company. Also, don’t invest in deposits over a year, say investment experts.
Fixed maturity plans (FMPs) are back in vogue. Tight liquidity conditions provide a good entry point for FMP investors these days. Investors can look at FMPs for 370 days, as they can give better tax-adjusted returns. Sure, the absence of indicative yields is a thorny issue.
But remember, the yield on an FMP is a function of the credit quality of the papers in the portfolio and the tenure. One can expect better post-tax yield on an FMP than a corporate FD of similar credit quality for equal tenure.
“Though FMP are listed on stock exchanges, given the low liquidity, you may not get the exit at all or may have to exit at a price substantially less than fair price,” says Richa Karpe, director-investments, Altamount Capital Management. If you cannot remain invested till the FMP matures, avoid investing them.
LONG-TERM INSTRUMENTS
In a rising interest rate scenario, the first thing most advisors will ask you is to stay away from long-term debt schemes.
However, there are many who argue that this need not be the case. “As corporate balance sheets have improved notably, income funds make a good investment sense with a two-to-three years’ horizon,” says Devendra Nevgi, founder and principal partner, Delta Global Partner. With inflation tapering off, long-term rates are likely to ease a bit.
If you do not want to take credit risk, you can look at gilt funds that invest in government securities. Since these are issued by the government, you don’t have to fear default risk.
However, you will be exposed to higher interest rate risk than in an FMP. But gilt schemes are highly liquid. Investors can also look at non-convertible debentures (NCDs) listed on the stock exchanges.
If you choose to invest in an instrument that doubles your money in the long term, say 78 months, you can enjoy long-term capital gains, which are taxed at lower rates compared with regular interest which is added to your income.
source:economictimes.com
How many times have you heard this refrain from someone, especially a retired aunt or an uncle, in the recent past? With living expenses soaring each day, most investors, especially those who swear by FDs and other relatively safer avenues like company deposits and mutual fund (MF) schemes, are in a fix. The expenses may mount, but their interest income remains steady.
They also have to worry about their investments in debt mutual funds, as a rising interest rate regime is bad news for these schemes.
INTEREST RATE SCENARIO
The Reserve Bank of India (RBI) has started raising the policy rate since February in its effort to contain inflation. It has increased the repo rate (the rate at which it lends to banks) by 1.25%, reverse repo rate (rate it pays to banks) by 1% and cash reserve ratio (the percentage of deposits banks have to keep with RBI) by 1% this calendar year to check easy liquidity.
According to investment experts, the banking regulator is likely to raise rates further. “We expect a 50-basis point increase in policy rates in the near future,” says Nandkumar Surti, chief investment officer, JP Morgan AMC. This means, interest rates — the key variable to watch out for a fixed income investor — are surely north-bound, at least, in the short term.
What do you do in such a scenario? Consider this: you can’t lock the money in long tenure FDs because you can’t take advantage of rising interest rates.
Also, you have to be very careful while investing in MF debt schemes because of the inverse relationship between the price and yield of securities. So, it is crucial that you pick instruments that match your investment horizon and risk appetite.
SHORT-TERM INVESTMENTS
If you are looking to park your money for less than a fortnight, choose a liquid fund.
The liquid-plus option is more suitable for an investment horizon of more than a fortnight. These funds can give better tax-adjusted returns than saving bank accounts. However, don’t treat these funds as investment avenues.
They are meant for parking money temporarily. For short-term investments of three months to a year, you should consider short-term bond funds.
Before investing, take a look at exit loads charged by the schemes, if any, as exit loads erode returns.
MEDIUM-TERM NEEDS
You can consider company deposits and Fixed Maturity Plans for your medium term investment needs. Company deposits pay a little better than bank FDs, but they are more risky. Always look at the credit rating of the company and don’t invest more than 10% of your debt portfolio in a single company. Also, don’t invest in deposits over a year, say investment experts.
Fixed maturity plans (FMPs) are back in vogue. Tight liquidity conditions provide a good entry point for FMP investors these days. Investors can look at FMPs for 370 days, as they can give better tax-adjusted returns. Sure, the absence of indicative yields is a thorny issue.
But remember, the yield on an FMP is a function of the credit quality of the papers in the portfolio and the tenure. One can expect better post-tax yield on an FMP than a corporate FD of similar credit quality for equal tenure.
“Though FMP are listed on stock exchanges, given the low liquidity, you may not get the exit at all or may have to exit at a price substantially less than fair price,” says Richa Karpe, director-investments, Altamount Capital Management. If you cannot remain invested till the FMP matures, avoid investing them.
LONG-TERM INSTRUMENTS
In a rising interest rate scenario, the first thing most advisors will ask you is to stay away from long-term debt schemes.
However, there are many who argue that this need not be the case. “As corporate balance sheets have improved notably, income funds make a good investment sense with a two-to-three years’ horizon,” says Devendra Nevgi, founder and principal partner, Delta Global Partner. With inflation tapering off, long-term rates are likely to ease a bit.
If you do not want to take credit risk, you can look at gilt funds that invest in government securities. Since these are issued by the government, you don’t have to fear default risk.
However, you will be exposed to higher interest rate risk than in an FMP. But gilt schemes are highly liquid. Investors can also look at non-convertible debentures (NCDs) listed on the stock exchanges.
If you choose to invest in an instrument that doubles your money in the long term, say 78 months, you can enjoy long-term capital gains, which are taxed at lower rates compared with regular interest which is added to your income.
source:economictimes.com
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