DEBT ALLOCATION

As a part of your debt allocation, the choices open to you are:

- Fixed Deposits of banks, post office, corporates, etc.
- Tax Free bonds
- Fixed Maturity Plans of Mutual Funds
- Short Term Debt Mutual Funds
- Longer Term Debt or Gilt Mutual Funds


There are inherent pros and cons for all these options.

1. Fixed Deposits of banks, post office, corporates, etc.
(a) Bank fixed deposit rates range between 9-10%. You do know exactly how much you get during the term.
(b) Fixed deposit of corporate rates is slightly higher depending upon the rating of the Corporate.
(c) For those in a top income tax bracket, even at 10% interest rates, the actual yield post tax (30.9%) would be 6.91%, where you would not be beating inflation.
(d) There is no scope for any capital gain or capital loss. What you give is what you get back at the end of the term.

2. Tax Free Bonds
(a) The Government of India has allowed four companies to issue tax free bonds. The first one to hit the market shortly will be NHAI. They will be 10 year and 15 year bonds.
(b) The interest rates, although not yet declared, will be 50 bps less than the 10 year GSec yield. The 10 year GSec yield has recently fallen sharply from around 9% to below 8.5%.
(c) At 8% interest rate on these tax free bonds, this would translate into 11.58% returns for those in the highest tax bracket.
(d) The bonds will be traded on the stock exchanges and hence there is scope for Capital Gains if interest rates of 10 year GSecs fall to the 10 year average of about 7%.

3. Fixed Maturity Plans
(a) The Fixed Maturity Plans are still giving 9.2 – 9.4% for a one year or 18 month FMP.
(b) There is a little uncertainty about whether the Direct Tax Code will be applicable next year or not. Hence for an 18 month FMP you do not know whether you will get double indexing (hence tax free returns) or single indexing, where some tax would be payable.
(c) However assuming the Dividend option the dividend distribution tax rate at 13.84% would give you net returns of 8.1% at 9.4% yield.
(d) Here too, you know what you are getting and at the end of the term there is no scope for capital gains.


4. Short Term Debt Mutual Funds
(a) The yield curve is currently quite flat. i.e. the short term and long term yield rates are the same i.e. around 9-10%.
(b) The RBI has announced that it will pause in the interest rate hikes. The bad IIP numbers of -5.1%, will ensure that the RBI should not hike rates on Friday.
(c) Government increased limit for FII investments in corporate bond and GSecs by US$ 5 billion each to US$ 15 bn and US$ 20 bn respectively. This has resulted in increase in demand.
(d) The Yield to Maturity of most short term debt funds are around 10% returns. After considering the expenses these yields to you should be around 9%.
(e) Short end of the yield curve offer attractive risk adjusted yields. The short term funds will continue to selectively increase duration as the yield curve is likely to steepen on the back of FII demand and improved liquidity.
(f) Hence, in the next one year, you are definitely looking at capital gains on the short term debt mutual funds and should be 10%-11%++ returns.


5. Longer Term Debt or Gilt Mutual Funds
(a) The was a large fall in the 10 year GSec yields in the last two weeks from over 9% to now below 8%. This was mainly because of:
i. RBI Open Market Operations
ii. Successful FII auction resulting in increased demand.
iii. Moderation in inflation and hope in interest rate easing
(b) However the Government of India is likely to over shoot the borrowing programme and that will result in hardening of interest rates again.
(c) RBI is not expected to cut interest rates before April or so.
(d) For those who can take the volatility in the debt portfolio, can invest in longer term debt mutual funds, to get 13-14% p.a. returns over the next 1-2 years. The average 10 year GSec yields are 7% and in the last GSec bull run the yields went down to 5% in 2009.


In Conclusion:
1. For any short term investments of 1 year or so duration invest in Short Term Debt funds. This is going to give you attractive 10%-11% returns without any risk.
2. However do keep 10-15% of your debt portfolio in longer term debt papers – to look at higher returns with volatility.
3. Take prompt action, because the last debt bull run lasted just 3 months.
4. For longer term investors, continue to stick to your asset allocation, which would depend upon your risk profile and the valuations of the market. It is never too clear when the equity bull market will re-start. The Sensex doubled from April 2009 to September 2009.