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Financial Planning: Choosing the right debt option

You may not be always right with debt, as some products require timing just like equity

While debt has always had its relevance for investors, its performance in the last one year has sent many rushing for it. Equity's under-performance in the last one year has only further made its case stronger with the equity market's weakness wiping out a few years' good performance at one go. While debt gives the comfort of capital safety and assured returns, not all debt options are safe in the real sense. In fact, debt can be a negative earner in a real sense if the choice of product is wrong. Hence, choosing the right debt product is as important as choosing the right stock, and in some cases, could be tougher too.

Interestingly, the challenge for many is when to allocate for debt rather than how to choose it. While the bad performance of equity automatically forces everyone to debt, it need not be the case if the investor resorts to asset allocation. If you go by the principles of financial planning, you would find that debt is an integral component for all categories of investors though the percentage of allocation may vary depending on the age and needs of the investor. For instance, young investors with limited sources of income but staring at financial commitments on a monthly or annual basis may not have the liberty to dabble with equity even if age were to be on their side.

For most other investors, debt is a necessity because of a number of factors such as protection of profits, and capital or asset allocation. Such investors probably have the luxury of altering the ratio towards debt, depending on the economic environment.

For instance, in the last 12 months, many high net wroth individuals preferred to stick to debt rather than go with equity because of the uncertain economic environment. Interestingly, a number of investors from this community began looking at the debt option way back in December 2007 when the equity indices were still on a rampage. The argument of these investors was that after the bull run for 3-4 years, investors need to turn to debt to protect profits. For some, the rising inflation and interest rates were other indicators for shifting the portfolio into debt.

In fact, during a conference in mid-2007, a fund manager of a leading insurance company commented that while investors were chasing equity, his fund was increasing its allocation towards debt and particularly in products like gilt and income funds. The performance of both these products is visible for all and unfortunately, even at current levels, the rush has continued for debt.

Those who are looking at debt for higher returns from the portfolio can look at products like gilt or income funds only with an investment horizon of 12-15 months as the returns from these schemes are likely to taper off once the rate cuts are completed. On the contrary, long-term investors can look at floaters or assured return products such as fixed deposits from companies, which offer double-digit returns. However, while parking funds in deposits, you need to take into account the tax angle as it would lower the effective yield.

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