Shrinking options

For equity investors, the going was literally never so good. Stocks are on fire, and the index pole vaulted from 2700 levels to 6000 in less than 6 months.

Yes, as I write this valuations have been slipping and the much feared correction is underway. However, this is typical of an overheated market where the cool down skims off the cream of the top.

All the fundamental macro factors that led the rise in the first place remain constant. GDP is growing at the rate of 7 per cent and our forex reserves are moving past the $100 billion mark.

Therefore, the thing to do is to recognize the opportunity offered by this correction and not panic. But that is a different story altogether for some other day. Today, we shall discuss the other side of the coin "" fixed income investing.

With equity hogging all the limelight, let's spare a thought for the risk averse fixed income investors. They are at their wits' end and do not know which way to turn. And the dilemma is justified, in that, over the past two months, some debt based schemes have even posted negative returns. Why has this happened?

Well, simply blame interest rates. Income funds carry essentially two kinds of risk. One is credit risk, where any of the instruments that comprise the portfolio may default. This risk can be reasonably mitigated by maintaining the quality of the underlying debt instruments.

However, the other risk, that of interest rates in the economy moving up or down, cannot be fully eliminated. The prices of debt instruments and consequently the NAV of the fund is inversely proportional to the movement of interest rates. Therefore if interest fall, the NAV will rise and vice versa.

So far interest rates were falling. However, now, most market players believe that the rates have bottomed out and will turn around in the near future. NAVs of income funds are moving adversely in sympathy with this feeling. That in short is the story behind underperforming debt funds.

So in such a scenario, what are the options for the investors? Let us consider some of them.

Monthly Income Plans (MIPs)
MIP is nothing but a name for a scheme that invests a part of its funds (anywhere between 15 per cent to 25 per cent) in equity and the rest in debt. These MIPs are currently being touted as a panacea for all evils.

If the debt portion is not performing well, the part of the portfoilio invested in equity would compensate and if equity were to underperform, then the debt based investments would arrest the fall in the NAV. But what happens when the equity market undergoes a correction and the debt market does not pick up? In such a scenario, the NAV will undergo a free fall.

This is not to say that it won't recover given time. When in any period, returns remain flat, the thing to do is have a long-term horizon where returns get accumulated over time. However, lets keep in mind the audience that MIPs cater to. These are largely income fund investors who have consciously stayed away from equity since they cannot afford the risk.

In any investment, the two main factors considerd are return and risk. In the case of MIP investors, the operating factor behind their investment is not so much return as risk avoidance. And if you are one amongst those, get into MIPs with your eyes open and aware of the possible downsides.

Liquid funds
Lets consider the other end of the spectrum, the liquid funds, variously known as short-term funds or money market funds. Here the portfolio is largely invested in liquid money market instruments such as commercial paper, certificate of deposits etc.

Obviously the interest rate risk is minimised here. Consequently the fluctuations in the NAV will be curtailed, however so is the return. These, by definition are a temporary pit stop, by no means meant for long-term investment.

So one could park one'sinvestible surplus in such short-term funds till a clearer picture emerges. Say three to six months down the line when there is a reasonably certain trend in evidence, the money could be shifted to long-term bond funds.

Floating rate funds
This is a relatively new vehicle. Investors in floating rate funds undertake the lowest interest rate risk, as anywhere between 70 per cent to 100 per cent of the portfolio is invested in instruments that carry a floating rate of interest, pegged in mostly to the Mumbai Interbank Offer Rate or MIBOR.

Unlike fixed income instruments prices of which will move as per the dictates of the interest rates in the economy, here the coupon is pegged to a (floating) benchmark which itself changes as per the general market rate.

Other fixed income instruments
Unfortunately the news on this front is not too good. Corporate fixed deposits are just not an option any more. The less said about bank deposits and tax saving bonds the better.

Enter PPF and Post Office savings instruments. Here, though the rates in the economy have fallen, they are being artificially kept high. There is a total mismatch in rates of small saving and post office schemes and the general market rates in the economy. Investors should take advantage of this anomaly.

Agreed, there are caps beyond which you cannot invest in these instruments and because of the associated lock-in there arise liquidity issues, however, wherever possible and how much ever possible, take exposure.

Last but not least
Good investing is more in the mind than in action. Whether you are invested in debt or equity, it is critical that you have a long-term perspective. Markets will respond to micro and macro events alike and one need not constantly react to the consequent fluctuations.

High returns are a thing of the past. Investors should be happy with market or slightly above market rate of returns. Also, be a little more vigilant. All income funds won't perform at a similar level as they did in the past.

Volatility in the debt segment would demand the best out of the fund manager. And if he is knows his business, then over even a year's time frame, short-term losses, if any, will be recouped and the portfolio adjusted for the new parameters.

So in short, the best thing that you could do is to stay invested, have a longer-term perspective and be aware.

The author may be contacted at anshanbhag@yahoo.com