Look beyond Ulips for your child’s future

Thirty-year-old Amit Goenka had just become a father of a baby girl. After the initial euphoria subsided, he decided to buy an insurance plan — Life Insurance Corporation’s (LIC) Komal Jeevan plan, a child unit-linked insurance plan (Ulip) to secure the future of the family’s newest member.


Child Plans:

He is one amongst the huge tribe of parents who have chosen to put their faith in child Ulips that promise continuity in the funding of the child’s education even in the event of the parent’s death. These schemes have been best sellers for most life insurance companies and thus form an important part of their portfolio.

It is easier to strike a chord with parents by talking about insulating their children’s future from any undesirable events. Consequently, selling child plans is easier as well. Many parents, thus, are completely taken in by the idea of achieving their dream of their child being able to complete his/her education in their absence.

In addition to the sum assured that is paid at the time of the policyholder’s demise, future premiums are waived off and the fund value is made available to the child on maturity. Riders providing for loss of income arising out of the parent’s (the insured) death or disability are also touted as one of the reasons why child plans score over other investment options.

Most companies also offer waiver of premium riders, which ensures that the company continues to pay the premium if the parent passes away. Over a period of, say 15 years, regular investments will ensure that the fund grows into a substantial amount, which may not be possible in case of a one-time , small lump-sum investment.

Mutual Funds:

Like several other parents, Amit, too, had various options to choose from. For instance , simple bank fixed deposits, Public Provident Fund (PPF), Reserve Bank of India (RBI) bonds, diversified equity mutual funds, post office instruments like monthly income scheme (MIS) and, of course, pure equity (stocks).

Most parents, if not all, invest in more than one product to secure the future of their children, provided the pocket permits the luxury.

Many fund houses also offer schemes dedicated for children. “Apart from two child Ulips, I also invested in a mutual fund scheme dedicated for children ,” Amit adds. For instance, UTI Mutual Fund offers CCP Balanced Fund and CCP Advantage Fund.

The two schemes, which collectively manage around Rs 3,000 crore, have given around 12% in the past. Anyone can invest in the name of his/ her child below the age of 15 years. When the child turns 18, s/he has the option of withdrawing the money completely or doing so in a phased manner. Some of the other mutual fund schemes currently available in the market include HDFC Children’s Gift Plan, ICICI Prudential ChildCare, LICMF Children Fund, Magnum Children’s Benefit Plan and Tata Young Citizens.

Look Before You Leap:

Most investment experts are of the view that these funds are not necessarily meant for children. They are more of a marketing gimmick which fund houses adopt to woo investors. After all, even a simple equity diversified fund is capable of generating a similar performance. The table above reflects the performance of such dedicated child mutual fund schemes over the past five years compared to the returns from the equity diversified fund category.

Why Equity?:

Remember, equity is the best- performing asset in the long run. While debt, or income , funds are considered ‘safer’ avenues, their ability to generate higher returns is also constrained . In contrast, equity schemes have the potential to deliver superior returns in the same timeframe. Also, since the children’s needs are a good 10 years or more away, you also have enough time to weather the volatility in the market .

Over the past 15 years, Sensex, the BSE benchmark, has given returns at a compounded annual growth rate (CAGR) of 13%. That is why investment experts want you to seriously consider equity schemes while investing to secure your child’s future.

Child Ulips Are Expensive :

Likewise, while it is convenient to invest in insurance plans, it is an expensive proposition. Financial planners are of the opinion that one should never buy an insurance policy with an investment objective in mind. They may be popular, but they are complex in nature, making an analysis of their performance an arduous task.

“Despite the cap on Ulip charges, the costs cannot be termed reasonable. Also, I don’t see them yielding significantly superior returns to justify the huge charges levied,” points out certified financial planner Amar Pandit. Child ulips are, in fact, costlier than even regular Ulips, owing to features such as waiver-of-premium and loss-of-income riders.

The Ideal Approach:

The best way to increase your kitty is by investing in diversified equity mutual funds with a good track record, as they are flexible instruments that offer the optimum mix of return, liquidity and tax-efficiency . However, the equity component means they come with associated risks. You should go for them if you are willing to stomach any short-term volatility and are prepared to dig in for the long haul.

“There is no doubt that starting a SIP (systematic investment plan) in a diversified equity fund and staying invested over the long-term is the right approach when it comes to financially securing your child’s future,” adds Pandit.

On an average, these schemes are much better positioned to tackle market risks, primarily because the constituents of a diversified equity scheme are determined by the fund manager who tries to encash upon the opportunities thrown open by the market from time to time.

The fund manager is at liberty to reduce the weightage of non-performing or volatile sectors or stocks in the portfolio and increase the weightage of the hot and roaring sectors.

A SIP in a large-cap , equity diversified fund should be combined with a term insurance cover to safeguard your child’s future. Though there is nothing to be gained in monetary terms if you survive the tenure of the policy, you would have ensured a large sum for your child in your absence at a fraction of a Ulip’s cost. However, don’t treat this lightly.

All the attractiveness of death cover, disability cover and so on can be obtained by pure insurance plans designed to cover them. This will make sure that your child’s future remains secure no matter what happens to the parent. Make sure that you have a life cover that is adequate — simply put, the cover should be enough to provide for sustenance of your family.

What must be kept in mind is that investing for a child is no different than investing for yourself. The principles remain the same.
Source:economictimes.com

Is this the right time to break your old FD?

Rising interest rates are always associated with expensive loans and an overburdened borrower. But this is just one side of the coin. The other side of the coin reflects the rising deposit rates, which have added some zing to this safe investment instrument. The bank fixed deposit rates (FDs) have increased in the range of 0.25-1 .5% across tenors. So is this the time to book fresh deposits or break your old one to benefit from the new rates?

Should You Keep Your Old FD?:

There is no single answer to this question. Investors should consider the time left before the date of maturity of their FDs before breaking the FD. For instance, if the FD is nearing maturity, it may not be a prudent decision to opt for a premature withdrawal. You will lose some interest income on that deposit, since the interest rate is calculated on an annualised basis . The loss in the interest income may offset the gain you earn from higher deposit rates.

As Suresh Sadagopan, certified financial planner , Ladder 7 Financial Advisories explains, “If you had invested around four months back for one year at 7.5% and the rate for one-year deposits has gone up to 8%, then on breaking the previous one, the rate applicable for four months, which maybe 5.5% will be applied. So, there is a loss of 2% on annualised interest or 0.66% for the period.”

The second factor to keep in mind is the penalty on premature withdrawals. “If the higher rates are able to compensate the penalties or lower rate for the tenure you have invested for, you could switch. If the rates have gone up by 0.5% and if the premature withdrawal penalty is also 0.5%, then there is no point exiting at this stage,” Sadagopan adds.

Most banks charge a penalty of around 1-2 % on premature withdrawal of fixed deposits. But if a customer has to withdraw before the actual maturity date, the bank may waive off the penalty. For example, SBI levies a penalty of 1% below the rate applicable for the period of time the deposit remains with the bank. “But no bank has a defined list of emergencies under which a customer can be spared from the premature withdrawal penalty. But banks have waived off this penalty for certain unexpected financial emergencies such as illness, death of a family member etc. But this waiver happens on a case-to-case basis and the customer has to convince the bank about the nature of his emergency,” says an industry expert.

Bank FD vs Company FD:

Most of the company FDs still offer a higher interest rate compared to that of bank FDs but one should also consider the financial soundness of the company. The safety and return on company deposits depend on the rating. Usually higher the rating, lower is the return . “Typically the return on an AAA-rated company comes very close to that of a bank deposit as the investor is assured of the company’s financial soundness. At times, public sector banks offer higher returns than company deposits,” says Kartik Jhaveri, certified financial planner, Transcend India.

For example, the rate offered by LIC Housing Finance on a one-year deposit is 7.6%. It is rated FAAA by Crisil, which indicates the highest degree of safety regarding payment of interest and principal. For the same period, SBI is offering 7.75%. Now this rate is comparable because the company has been given a safe rating. Also, in most of the cases, it takes a longer time to get the credit in case you want to break your company FD before its due maturity. But at today’s FD rates, there is not much of a difference, feel financial advisors.

“Also, banks typically give a 0.25%-0 .5% more for senior citizens. Hence, it could be a good idea to consider bank FDs themselves at this point of time,” Sadagopan adds. Bank deposits up to . 1 lakh are covered under the Deposit Insurance and Credit Guarantee Corporation (DICGC), which adds to the safety blanket. However, there is no protection for depositors if a company is in financial trouble as FDs are a part of a company’s unsecured debt.

A company’s non-convertible debenture is a safer bet than a company FD, as it comprises a part of se-cured debt. Company FDs have traditionally offered higher interest rates than those of banks. Companies come out with deposit schemes whenever they require cash to fund their business activities. If these companies are highly cash-strapped , then they will offer even higher rates to woo the public money. One of the biggest risks associated with company deposit rates is the default risk.

Even if the company has a fair reputation in the market, it may not be in a position to pay off your money and interest on time. This is because they tend to invest the money (you park in form of deposits ) for specific use, which carries a higher default risk. Unlike, banks which lend your money to several borrowers and companies, the risk is diversified. So, the impact is lesser.

Hence, in case of company FDs, you have to see if it has been rated by any agency like Crisil, Icra etc. Then, one can look at the number of years in business, profitability of the company, the reputation of the promoters etc. If you know of people who invest in FDs, try to find out if they are prompt in sending the maturity proceeds, interest cheques, and how responsive they are.

How to calculate your actual return?:

Banks are offering 8.6% on one-year deposits. This could be higher depending upon the com-pounding effect. If a bank compounds the interest on a quarterly basis , the actually rate would be higher at around 8.8%. More the number of times a bank compounds the interest, higher is the interest income. But that is not the ultimate realisable return you earn on the deposit. Given that the interest income on bank deposits is fully taxable, the net yield is much lower. If a person is in the highest tax bracket, then the actual return after tax of 30.9% is 5.6%. It will be commensurately higher for those in the lower income slabs. Income from FD is fully taxable as income. Also, bank FDs tend to yield relatively lower interest (in view of their lower risk profile).

“Bank FDs offer assured returns but they are taxable at a slab rate which may go up to 30.9% for individuals under the highest tax bracket. An investor whose income is above . 8 lakh will get the net yield of 5.528% if the FD offers an interest rate of 8% per annum. For instance, if you fall in the 30% tax bracket (income above . 8 lakh in the current financial year), your tax liability will be . 1,236. Now, if you invest . 50,000 and get . 54,000 on maturity with 8% interest, the net yield will actually be 5.528%,” says Pankaj Mathpal, CFP managing director Optima Money Managers.

FDs can’t beat inflation:

Inflation, as an economic indicator, reflects the value of money over a period of time. Inflation has the abil-ity to erode the value of your investments even as you may have earned some return on them. Whenever you invest in an instrument, compute the future value after accounting for inflation of 8-10 % to get accurate results. Let us assume you invested Rs 1,000 in a one-year fixed deposit at 7%.

The value of the deposit will be Rs 1,070. But if the inflation has been 8% of the year, the value of Rs 1,000 decreases by Rs 80. The net value of your money is Rs 990 only. So, the net gain after computing the loss of value due to inflation is actually negative. Bank FDs are an essential ingredient in everyone’s investment kitty.

They act as a good balance in a portfolio. Low risk-free avenues such as bank deposits and small savings have gained prominence due to vagaries of risky instruments linked to equity market. But FDs alone cannot grow the size of your portfolio. Hence, FDs should just be a small component of your investment portfolio. “It should be around 15% for an investor at the start of the career or nearing 30s, 25% for an investor at 40, about 35% for an investor nearing retirement, (another 25% could be in other debt instruments like PPF, debt funds, FMPs etc.),” Sadagopan adds.
source:economictimes.com

Should you buy Infrastructure Bonds?

This question is echoed by many investors. Infrastructure bonds are certainly not new to the Indian taxpayer. They did exist till 2005 when Section 88 of the Income Tax Act was in force. In the last Budget, these bonds were re-introduced under Section 80CCF.

However, there seems to be a mis-conception in your thinking. These bonds do not compete with equity linked savings schemes (ELSS). Tax saving funds fall under Section 80C of the Income Tax Act. Under this section, tax payers get a tax deduction up to Rs1 lakh. These infrastructure bonds will give you an additional tax deduction of Rs20,000, over and above the Rs1 lakh that you are eligible for under Section 80C. In effect, a total tax deduction up to Rs1.2 lakh on your income. So the first thing you must make note of is that you should consider these bonds only if you have exhausted all the limits under Section 80C.

Let’s look at the tax aspect. Do pay attention to the fact that the income earned from these bonds will be added to your taxable income in the year in which you realise it. It is not an EEE (exempt-exempt-exempt) proposition like the Public Provident Fund (PPF). Just like other tax saving instruments like National Savings Certificate (NSC) and 5-year bank fixed deposits, the interest earned is taxed. Under an Equity Linked Savings Scheme (ELSS), long term capital gains tax is nil and dividends are tax free, so there is no tax burden. Neither is there one in the case of PPF. All these options fall under Section 80C, the infrastructure bonds being outside the purview of this section.

There is also the liquidity aspect. These bonds come with a long tenure of 10 years and a lock-in of 5 years. If there is no convenient secondary market, then you will effectively have a lock-in of 10 years. Although some issuers will provide a guaranteed buyback, ensure that you do not need the money for a minimum 5 years.

Unlike other tax saving investments like NSC or PPF, these bonds don’t carry any implicit or explicit government backing. Combined with the tenure of these bonds, it will mean that the continued creditworthiness of the bond issuers is something that investors will have to keep an eye on. Agreed, IFCI, PFC, IDFC and L&T Infrastructure are sound companies, but we are taking a view over a decade here.

Only after you look at these aspects should you make a decision on whether or not to invest in the bonds. A tax-saving investment has to be an investment first and a tax saver later, in the sense that if you wouldn’t be investing in that asset otherwise, then you shouldn’t do so just because it’s saving some tax. Moreover, the upper limit of Rs20,000 means that many taxpayers in the upper tax bracket will find the quantum of additional tax savings to be marginal.

source: valueresearchonline.com

More than just an SIP

If you are a mutual fund investor, you need no further explanation on what an SIP is. Every fund house aggressively preaches the benefits of systematic investment to whoever gives an ear. Its not-so-common sibling is the STP. But if you thought that this was all there was to fund investing, other than the invest-at-one-go style, which we caution against, by the way, it's time for an update.Fund houses have donned their creative hats and structured innovative ways to supplement the conventional SIP. Here's what is available in the market.

SIP

It's easy, it's convenient and it works for the investor. In a systematic investment plan (SIP), a fixed amount is invested in a fund at a predetermined date, which could be either monthly or quarterly. Not too long ago, daily SIPs were also introduced.

STP

A systematic transfer plan (STP) is a combination of a systematic withdrawal plan (SWP) and SIP. Under a STP, a pre-determined amount is redeemed every month from the fund at regular intervals. For instance, the fund house withdraws a fixed amount at a pre-determined frequency from either a debt or liquid fund, where the investor has invested his/her initial corpus, and channelizes the investment into another fund chosen by the investor. Generally there are two asset classes at work. The initial corpus could rest with a debt or liquid fund and periodically money may be transferred to an equity fund.

DTP

The dividend transfer plan (DTP) resembles the dividend reinvestment plan (DRIP). The dividends that an investor earns in a scheme, gets reinvested in another scheme from the same fund house. Not the same scheme (like dividend reinvestment), just the same fund house. An investor can essentially structure his investments in such a way that dividends from, say, his debt fund get reinvested in an equity fund of his choice.

VIP

The value investment plan (VIP) was introduced by Benchmark Mutual Fund. Before investment is initiated, a target rate of return that has to be achieved monthly is decided. After the first installment, subsequent investments made are based on a formula, which is that the amount invested will be the difference between the target and actual value of investment (see illustration).
So if the market movements are below the desired rate of return, subsequent investment rises to make up the short fall. Benchmark Mutual Fund also has value transfer plan (VTP), where the same strategy is implemented by withdrawing from a debt fund and re-investing the proceeds in an equity fund.

FLEX STP

Introduced by HDFC Mutual Fund, this one is a compromise between SIP and VIP. The initial amount is invested in a debt or liquid fund. After that, it's either the pre-determined installment amount or the difference between amounts invested and value of the invested amount. Like VIP, if the market is on a free-fall your subsequent investments can easily exceed your total planned investment.

Smart STEP

This one, introduced by Reliance Mutual Fund, follows an in-house quantitative model which can judge the “current positioning of the market” based on its intrinsic volatility. Even though the fund house explicitly hasn't stated it, it implicitly suggests that the model can estimate whether the market is over- or under-valued. On a pre-determined day, accordingly to the output from the model, a low, medium or high amount will be invested in the fund. Since they haven't been very forthcoming in sharing the details of the model, we are unable to determine the efficacy of it.

FLEXINDEX

Conceived by HDFC Mutual Fund, investors have to choose four levels of the index at which they would like to deploy their money. If that level is crossed or met, either one-fourth of the total would be invested or a percentage of the total as specified by the investor. If you take a look at our illustration, we failed to deploy our planned investment in any one of the years. So a comparison with other investment strategies is unfair.

SIPs and STPs are not fancy, but they are easy to grasp and get the job done. As in, they don't let the market sentiment affect the investment decision. Their premise is based on the underlying theory that in the long run, equity can deliver superior returns if investments are done rationally in a disciplined fashion.
These innovations are more sophisticated in the sense that the amount invested can be tweaked and the investment can also be timed to some extent. But frankly, after we did a comparison, they appear to be more gimmicky than anything else. To top it all, they will throw your equity:debt planned allocation out of the window.

source: valueresearchonline.com

FMPs - Fixed Maturity Plans

What are FMPs?

These are schemes with a fixed maturity date i.e., they run for a fixed period of time. “This period could range from 15 days to as long as two years or more. Like in an FD, when the period comes to an end, the scheme matures, and your money is paid back to you,” says Sandeep Shanbhag, director, Wonderland Investment Consultants, a tax and financial planning firm.

Most FMPs being launched these days have a maturity period or tenure ranging from a little over a month to a little over a year.

"There are FMPs for one month (up to 35 days), three months (up to 100 days), six months, one year (367-370 days), two years and three years — most common are one month, three months and one-year tenure," says Vijay Chabbria, a chartered financial analyst who runs Prudent Investment Advisors.

What are the returns these FMPs are likely to offer?

"The returns on a three-month FMP are at around 7.25-7.5% per year whereas the returns on a one-year FMP are around 8-8.5%," says the head of fixed income of a mutual fund who declined to be named. This was confirmed by another head of fixed income of a mutual fund and a couple of financial advisors.

It was standard practice among mutual funds to give out indicative returns on FMPs before investors invested. They managed to do this because an FMP which matures in 370 days invests in financial securities maturing in the same time period. This gave mutual funds a fair idea about the returns on offer.

Depending on the return the securities maturing in one year were giving, the FMP gave an indicative yield to the mutual fund distributors. This practice was banned by the Securities and Exchange Board of India (Sebi) in early 2009. Mutual funds, of course have gotten around this by verbally communicating to their distributors on the likely return to be expected on an FMP.

FMPs vs FDs

Most one-year FDs offer a return of around 6.5-7% to ordinary depositors and 7.5% to senior citizens (people over 60). Meanwhile, one-year FMPs offer a return of around 8-8.5%. So, at a very basic level, FMP returns are higher. Once we take into account the tax treatment for the gains made on both FDs and FMPs, the net return earned on an FMP is much better.

Says Shanbhag, “What gives FMPs the edge is the greater tax efficiency they offer. In other words, on a tax-adjusted basis, the return on an FMP is higher than that of a bank FD.” The entire interest earned on an FD is taxable, depending on the tax bracket you fall in. For those falling in the 30.9% highest tax bracket, the real return from a one-year fixed deposit paying an interest of 7% is around 4.84%.

However, the return on an FMP is categorised as a capital gain. So, for a period of more than one year, an FMP is taxable at the rate of 10% without indexation or 20% with indexation, whichever is lower. For instance, an individual invests Rs 50,000 in an FMP. The rate of inflation is 5% and the return on the FMP after 370 days is around 8%. This means that the investor gets Rs 54,000 at maturity, which implies a gain of Rs 4,000.

This gain taxed at the rate of 10% would mean a tax payment of Rs 400 and a net gain of Rs 3,600 which would imply a return of 7.2%. If we take indexation into account, the cost after inflation goes up to Rs 52,500 (Rs 50,000 + 5% of Rs 50,000). So, the capital gain in this case is Rs 1,500 (Rs 54,000 – Rs 52,500). And a 20% tax on this works out to Rs 300, which is lower than the Rs 400 tax that needs to be paid without indexation. So, the net gain is actually Rs 3,700 (Rs 4,000 – Rs 300), or 7.38% (Rs 3,700 expressed as a percentage of Rs 50,000).

Now compare this to 4.84% return you earn in case of a fixed deposit, it tells you very clearly where more money is to be made. As Chabbria puts it, “The tax benefit due to indexation and the fact that interest on bank FDs is fully taxed makes FMPs a good bet.”

How to invest in an FMP?

Mutual funds offer FMPs all the time. “FMPs are more popular towards the end of a particular quarter. The month of September saw a launch of a lot of FMPs. Now, December will see a lot of schemes being launched,” says the head of a fixed income at a mutual fund.

Should you invest now or wait: RBI has increased the repo rate (the rate at which it lends to the commercial banks) by 125 basis points in this financial year. If interest rates are poised to move further up, then it makes sense for investors to wait. If they are not, it makes sense for investors to lock in their money right now. We polled experts to get their view on this. And as is the case usually, they are divided on the issue.

“The short-term interest rates are nearing their peak. This indicates an opportunity to lock in money with a one-to-three-year timeframe,” says Nandkumar Surti, chief investment officer, JP Morgan Asset Management. This is something with which Joydeep Sen, senior V-P, advisory desk-fixed income, BNP Paribas Wealth Management, agrees with. “Returns on short-term financial securities (which FMPs invest in) have already moved up and there is limited scope for returns to go up more.”

It makes some sense to park your money in FMPs right now

But not all share the same opinion. “Short-term interest rates are likely to go up further as the initial public offerings(IPOs) and follow-on public offerings (FPOs) by companies in the stock market will suck out money along with further issuances of certificate of deposits by banks,” says Pankaj Jain, fund manager, fixed income, Taurus AMC.

What this means in simple English is that the demand for money from corporates and banks is likely to go up in the days to come, thus pushing up interest rates further. Adds a head of fixed income of a mutual fund, “I will not be surprised if the returns offered on FMPs with a greater than one-year maturity touch even 9%.”

So, given this disagreement among experts, it makes some sense to park your money in FMPs right now. “You will be better off investing more than half of the money you allocated to FMP now,” says Sen of BNP Paribas Wealth Management. “Why wait for a 20-25 basis point uptick in returns when you really cannot time it?” asks a strategist with a foreign wealth management services provider. The bigger issue is that there is no guarantee that retail investors get enough options in FMP space in the last quarter of the financial year. A bird in hand is better now than two in the bush later is the simple reasoning wealth advisors are offering as they advise investing now.

Risks of investing in an FMP

Generally, considered to be a safe instrument, nonetheless, retail investors should exercise care before committing their funds, given that returns on a bank fixed deposit are more or less guaranteed and returns on an FMP are not.

Given this, it makes sense for investors to invest only in FMPs of mutual funds which have a pedigree and reputation.

source: economictimes.com

Financial Planning - An evolved way out for Asset Allocation

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

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