How safe is debt?

Abhijeet Sharman (Name changed) began reallocating his corpus from equity to debt funds and bank fixed deposits (FDs) since January this year when yields on debt began to perk up and equity markets began to tumble. The 32-year-old marketing manager’s mix of liquid plus funds did well for most of the year in tight market conditions. “I was expecting good returns from fixed-income investments as there was a perception that interest rates have peaked,” says Sharman, who invested heavily in liquid plus funds.

But things took a shocking turn just a few weeks ago. Liquid and liquid plus funds witnessed huge redemptions as companies pulled out money from these funds for advance tax payments. As a result, many liquid funds posted negative returns for a few days. Sharman’s total debt portfolio was down by 65 per cent of its original value.

As things stand today, the debt market has stabilised after the Reserve Bank of India (RBI) cut cashreserve ratio and opened a separate window for mutual funds to borrow against certificates of deposit. But the crisis highlights one fact: that debt is not entirely safe. Says Pradeep Dokania, Head (Global Private Client), DSP Merrill Lynch: “With the impact of the global credit crisis unfolding in the investment world, much of the pain is felt by small, retail investors. And this has also shown how relatively safe investment avenues such as debt can turn sour.”

So, before you invest in debt, consider a few aspects of the debt market. The risks involved with debt are different from those in equity, and a glitch in any of them will hurt your returns significantly.

Debt is still good
As of now, debt is still a good place to be in as yields are still good. RBI’s recent repo rate cut by 100 basis points to 8 per cent can drive the yields down, but that will happen slowly and banks are yet to reduce rates. Says R. Swaminathan, Head (Institutional Business Group), IDBI Capital: “Today, the scenario is entirely different. The yields on debt instruments are almost at a peak and the measures to infuse liquidity may keep interest rates in check over the near term. Influencing factors like inflation are on the downward direction. For investors with a low risk profile, there has never been a better time to invest in the debt instruments.”

While all these developments have made debt instruments reasonably attractive, one should take decisions depending on one’s investment horizon and liquidity needs. For example, investors in the highest tax bracket can consider investing in short-term debt funds. But do look at the liquidity risk and interest rate risk. On the other hand, for investors in lower tax brackets, FD investments should be the preferred avenue.

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Liquid gains: Liquid and liquid plus funds allow you to park your money for short periods, but make sure that you don’t do a distress sale in this product. The pure liquid funds invest in money market instruments, shortterm corporate deposits and Treasuries with maturities of less than a year; liquid plus funds, on the other hand, invest in slightly longer-term paper to generate better returns. Besides, liquid plus comes with a slightly higher risk than plainvanilla liquid funds.

Says V. Ramesh, CEO, Prabhudas Lilladher Financial Services: “Investors can continue to invest surplus money in liquid and liquid plus funds for effective treasury management for the short term. If one is looking at an investment horizon of 15 days to three months, one can look at liquid plus funds.”

Where do debt funds invest? Less than one year Commercial Papers: They are short-term papers issued by companies to cover their short-term borrowing requirements. The risk is quite low due to a lower tenure. Short-term debt funds invest in these papers. Certificates of deposits: It is the same as a commercial paper, except that these are issued by banks. Usually, short-term funds or FMPs invest in these papers. Collateralised borrowing and lending obligation (CBLO): This is basically an overnight window, which is offered by the Clearing Corporation of India. Funds invest here only for a day or two. This facility is used by liquid funds. Treasury Bills (T-Bills): They are issued by the Government of India and usually have tenures of 90, 182 and 364 days. They are extremely safe as they carry a sovereign guarantee. Again, short-term debt funds invest in these securities. One year and above Corporate Bonds: These are bonds issued by PSUs and are rated by credit rating agencies. Medium-term and long-term debt funds usually invest in them. Debentures: Issued by Indian companies, these bonds are also rated and medium and long-term bond funds invest in them as in accordance with their investment mandates. Securitised paper (Pass through certificates): These are papers issued by banks securitising a loan that they have offered to a single corporate entity. Longand medium-term bond funds invest in these certificates. Government bonds (Gilts): These are bonds issued by the government of India and carry sovereign guarantee; hence, they are highly safe. There are special gilt funds that invest in the government bonds.

Fixing it with FMPs: With bond yields heading north and interest rates ruling high, fixed maturity plans (FMPs) have become the flavour of the season. Asset management companies are offering FMPs with yields as high as 11.5-12 per cent. These specially designed close-ended funds invest in debt paper that will mature around the same time the fund matures. For instance, a one-year FMP will invest in bonds that will mature in one year. Any withdrawal before the due date invites a steep exit load. Besides promising indicative returns at the start of the tenure, FMPs also offer tax advantages.

But look at the target portfolio of FMPs before you invest. Some AMCs have been compromising on credit quality by investing in high-yield paper of real estate and non-banking finance companies (NBFCs), which may, in the current scenario, be risky.

Profit from gilt: Compared to income funds, there are fewer qualitative issues relating to gilt funds. Gilt funds invest in government securities, which don’t carry any credit risk. Analysts believe that in the current credit crisis, apart from FDs, gilts are the only debt instrument where you can park your money for the medium- to long-term period.

Says K. Ramkumar, Head (Fixed Income), Sundaram BNP Paribas Mutual: “It is difficult to invest directly in G-secs as the normally traded lot size is high. Given the convenience of buying and selling Gsecs through MFs, gilt funds will be the most preferred way of investing in these instruments.”

But gilts are subject to interest rate risks. Hence, one should ideally avoid them when rates are rising. Says Dokania: “But now, as the rate of interest moves south, the yield of gilt funds should move upwards. This will ensure that investors can earn some very good returns from them.” Gilt funds, which are open-ended and provide redemption and sale facility on a daily basis, on an average, have generated returns of around 12-13 per cent over the past one year.

Bank on them: As of now, bank FDs have also turned attractive, and have emerged as the safest haven for investors. On safety front, this option tops the list with almost zero default risk. Says Dhirendra Kumar, CEO, Value Research: “Bank FDs are safer as they are subject to control by RBI. Today, investors also have reasonable grounds to park money in savings account as they are safe and offer guaranteed interest for a specified period.”

Depending on the tenure of the fixed deposit, investors should be able to make the most of the rising interest rates as banks rush to raise additional resources. But given that RBI has cut interest rates, conservative investors better hurry before interest rates start cooling off once again.

Look before you invest Assess the kind of securities your fund will be investing in, and the type of risk associated with debt. The rate risks Before you get started, it’s important to understand the risks associated with debt markets. For one, the first risk investors should bear in mind is the rate risk. Interest rate movements have an inverse relationship with the net asset value (NAV) of a fund. If rates rise, the NAV of a fund comes down. Hence, longer-tenure funds such as medium-term bond funds or gilt funds will get affected. Liquidity risks Lately, debt funds have faced severe redemption pressures as companies reeling under the liquidity crunch pulled out money from liquid and debt funds. Reason? Banks tightened working capital loans for companies. This saw a lot of distress selling by mutual funds due to redemption pressures. Says Kumar: “In order to cope with the situation, companies are trying to tide over the crunch by redeeming their investments in FMPs and liquid funds. Also, the risk for retail investors is that they may be left holding not-so-good assets.” If a fund carries a lot of illiquid paper, it is susceptible to defaults. Common illiquid papers that mutual funds hold comprise securities issued by finance companies and also securitised papers or pass through certificates (PTC), and a few corporate bonds.” Default risks Lastly, debt issuers can default on their interest or principal payments. This is particularly true of those companies that succumb to the slowdown or are very lowly rated. A credit default will hit the NAV of a fund very badly and investors could lose all of their gains. The safe avenues Gilt Funds: Since they invest in government securities, investors need not worry about credit risks. Besides, as RBI eases interest rates, these funds will gain from an increase in their net asset values. Bank FDs: They have been offering extremely high interest rates for deposits for one-to-three years. Senior citizens get an additional 50 basis points interest. Invest here for the short-term. Fixed Maturity Plans: Look for short-term FMPs that invest in pure bank commercial deposits or short-term government paper. Avoid schemes that invest in real estate or NBFCs.