World Colleges Information

Investments can be a tricky area, if you venture into it without doing your homework right. Let’s look at few such commodities and investment entities which can quickly fill in your pockets this season.

Only a handful of Indians see debt as an active investment avenue. Very conservative investors never move beyond fi xed deposit (FD) as an investment. More active investors regard this as a way to earn some interest on surplus funds, before putting the cash into more high-risk, high-return assets.

Debt funds aren›t very popular and, after the last Budget removed a tax-arbitrage opportunity, these are likely to lose appeal further. The lack of a deep, liquid secondary bond market also restricts options. There are very few corporate bond issues and, in effect, these cannot be traded and must be held to maturity.

However, despite the downsides, it is worth calibrating debt investments to changes (or anticipated changes) in interest rates. There are periods when debt can be quite profi table, as well as low-risk. Typically, debt is reckoned low-risk or risk-free if return of principal is assured or very likely. But a debt instrument may give returns well below infl ation and so, erode the value of the principal.

Bank FDs are thought of as the closest to risk-free returns for individuals, though these are technically guaranteed only until an upper limit of Rs 1 lakh an individual. Government Treasury Bills are the risk-free equivalent for institutions (individuals can buy T-Bills in theory, but it›s very cumbersome in practice).

Any return must also be adjusted for infl ation, or expected infl ation. The real return from debt might be negative even when nominal interest rates are high. Every return from every other class of fi nancial assets can be compared to the FD as a proxy for risk-free return. There is a subjective element attached, as for investments such as equity, we know neither the return nor the risk.

Indian banks set market-determined commercial rates. They offer the rates they think investors will fi nd attractive and, of course, there is competition. In practice, deposit rates tend to be within a fairly tight band and there is a tendency for interest rates to lag changes in infl ation trends.

In general, if interest rates are falling, the value of a portfolio of existing loans (disbursed at higher rates) rises. Conversely, if interest rates are rising, the value of a portfolio of loans (disbursed at lower rates) falls. This trend is evident in T-Bill auctions. If interest rates rise, T-Bill yields also rise, as the price of the T-Bill falls. Conversely, yields fall and T-Bill prices rise if rates fall.

If the real interest rate is negative, the smart investor could be seeking avenues other than debt, where potentially higher returns might be available. If the real interest rate is positive, money might fl ow into debt instruments.

In the past year or so, we›ve seen the Reserve Bank of India (RBI) raise policy rates twice and, subsequently, maintain status quo. Now, it appears infl ation could be falling, at least the central bank hopes so. If infl ation does drop, RBI is likely to start cutting policy rates in early 2015. Banks will start to cut commercial rates only after RBI takes action.

If the infl ation trajectory is in line with RBI›s targets, it will drop through 2015. In that case, interest rates could also show a falling trend. If this scenario holds good, a strategy of buying into FDs with a timeframe of one-two years should be good. By November-December 2014, the investor should also look at debt funds, which will see capital gains through 2015, if infl ation keeps falling.

Inflation-indexed bonds:

The RBI is likely to soon launch infl ation-indexed national savings securities through banks. The interest offered will be CPI plus a premium of 1.5%.

The CPI rate used to calculate the coupon will be three months old. That is, the coupon of bonds issued in December will be based upon the CPI level of September. If the CPI infl ation in September was 10%, the minimum coupon on an inflation-indexed bond will be 11.5%.

With CPI in October and November staying above 10%, infl ation-indexed bonds issued in the next couple of months will have a coupon of more than 11%. However, interest earned on these bonds will be taxable. This makes them less attractive for investors in higher tax brackets.

“Inflation-indexed bonds are quite attractive as a concept. However, on a closer look, the structure suggested by the RBI makes it a negative real return product because of the tax incidence. The product is attractive only for retail investors who are in the lowest tax bracket”.

BUDDING MANAGERS

JANUARY 2015 ISSUE