Last week, I attempted to simplify the RBI credit policy for your understanding. This week, the agenda is to delve deeper into debt mutual funds which invest in fixed income instruments and compare them with their traditional counterparts of bank deposits or corporate fixed deposits. It is important to compare likes to be able to make a correct evaluation. A friend of yours may pooh-pooh your belief in financial planning because he's made good money at horse races or at a casino, but — you be the judge — tell me what proportion of "betters" ends worse off actually in this quest.
Duration Is The Key
In fixed income investments, duration is the key. That is, for how long you are committing to invest. Normally, interest rates rise with increasing tenure, as you may well be aware when you compare bank deposit rates. You may have money to invest for a year, but would like to get the flexibility of the option of withdrawing it every 3 months without any penalty. While you actually renew the deposit thrice and the money remains with the bank for the same 1 year, the rate of interest paid is lower than what you would have otherwise got had you committed to keep the funds with the bank for 1 year in the first place.
Asset Liability Mismatch
My previous work experience with an NBFC in the 1990s taught me the importance of not having an asset-liability mismatch. If we were financing vehicle purchases for three years, we needed to have enough funds raised for the same period. Of course, we got 1-year deposits cheaper than 3-year money, but we carried the risk of liquidity — in case the deposits did not get renewed, it was not possible to close the car loan to repay the deposit holder. If we were ultra safe and raised money for 5 years — at a higher rate than 3 years — profitability was impacted.
Investing In Debt Instruments
Default risks can be reduced by investing in government securities (or gilts) which are deemed to have lowest risks, followed by AAA-rated bonds. Since interest rates fluctuate on a daily basis, the price of the bond also varies — it could be up or down.
However, if the instrument is held till maturity, there is a certainty of return which is known at the time of entry itself. However, these safe instruments are not easily traded in the market and an easy way to invest is through mutual funds. As mentioned in my column last week, there are 100% gilt funds which have earned 3-year returns of 10.65% p.a. compounded annually.
Rates Go Up, Prices Down
As financial planners, we recommend entry into gilt funds on a staggered basis at this time. Since prices fall when rates go up, is this advisable? We did an analysis of five gilt funds and found that if rates increased by 100 basis points (bps) or 1% in the next one year, returns for these funds would only be between 1.7% and 3.5% for the year. However, if the entry is staggered into one-third now, one third after rates have jumped by 50 bps, and the last one-third after rates have jumped by 100 bps, returns in these same funds would range from 8% to 10.6% for the year. Debt markets are more difficult to understand by the lay person and hence, we recommend you to take professional advice before you venture into these uncharted territories.
