Debt instruments: What 2007 holds

Updated: Dec 31 2006, 06:50am hrs
Debt as an asset class has lost its sheen on the back of rising equity markets. Though the investor preference is moving from debt to equity, investments in various types of debt far outweigh the equity investments. It is observed that barely 2.5% of the Indians have exposure to equity, clearly underlining the weight Indian investors offer to debt. However, amidst rising interest rates and volatile liquidity in the market, the fixed income instruments have left few opportunities for retail investor.

In the past year, investors experienced interest rate hikes and CRR hikes from the central bankers. The situation was, however, relaxed due to subdued oil prices from the peak experienced in the mid 2006.

Post the hike in reverse repo rate and the CRR hike, RBI has signalled the increasing hit in certain pockets of the economy. This certainly impacted the liquidity in the market. Obvious outcome of which is rise in interest rates, pulling the bond prices down. This is detrimental to the long-term bond funds. Other initiatives like allowing short selling in government securities further enhances the price discovery in the bond market. Participation from FIIs may further add to the demand for bonds in the Indian market. However, the impact is expected to be minimal on account of few arbitrage opportunities for FIIs in the near term. However, it is more of a policy measure allowing FIIs in Indian markets. These initiatives by RBI are expected to enhance the debt market.

The inflation is an area of concern. RBI has estimated inflation to revolve around 5.5%. Recent numbers are near this target and in future the inflation numbers may go beyond the RBI estimates. Rising inflation is bad for both the consumers as well as the bond investors. The rise in inflation pulls down the real rate of return available to the bondholders.

The real rate of return on an 8% earning one-year bond stands at 2.5% after adjusting for 5.5% inflation. Going forward, maintaining the real rate of return is an uphill task for the investors. The real rate of return should be seen as a key determinant of investment in debt instruments or debt mutual funds.

Though short-term bond fund may outperform their long-term counterparts, it may not offer a good risk reward ratio compared to the ultra short-term or liquid mutual fund. The coming year is expected to be the year of liquid funds and floating rate funds.

In the debt segment, liquid funds can become the place to be in. RBI's measures to curb liquidity along with other factors such as rising credit demand, burgeoning government expenditure will ensure that the interest rates remain firm, if not go up, in the year to come. This will ensure that the short-term interest rates also remain firm. The yield curve across maturities in India is flattening, on account of falling term spreads, making it an investment case for the ultra short-term or liquid funds. Liquid funds are expected to deliver tad above the one year fixed deposit rate of return. Also, liquid fund is a cost effective way of investing in ultra short-term debt.

Liquid funds ensure that the investor is well protected from the rate hikes in the future as the call money market rates are adjusted accordingly, avoiding any losses to the investor on account of rise in interest rates. High liquidity offered by the liquid funds further ensures that the same is also useful for the equity investors in times of volatility.

Floating rate funds are another avenue investors may look at. This creed aims at investing in primarily those instruments that offer floating rate of interest. These funds ensure that the investor won't lose in case of rise in interest rates. However, lack of depth due to limited number of issues of floating rate instruments offers fewer opportunities to investors.

Debt as an asset class may not appeal to those who prefer returns to risks. But if one looks at debt as a means of safeguarding his capital in the volatile equity markets, it certainly offers options. And for those who need security of capital along with decent returns, debt is an easier solution, though selectively.