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BW Businessworld

Fixed Income To Gain Spotlight

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For 10 to 15 per cent of the total portfolio year 2011 has been a mixed bag for Indian investors. While equities and the rupee have fallen over 20 per cent, gold has given huge returns mainly due to the rupee depreciation. For most investors, real estate returns have only been on paper. Given this backdrop, 2012 starts on a note of uncertainty.

Inflation is high and is not falling fast enough. Growth is slowing down. Interest rates are high on a nominal basis but negative on a real basis and volatility is the order of the day.

The current prices of all asset classes factor in all the bad news on growth, inflation, tight liquidity, rupee, policy paralysis, interest rates and global uncertainty. If the real news is worse than perceived, then markets will fall, while if it is better than perceived then the markets will rise.

In such an environment, it is appropriate to maintain asset allocation in line with one's risk profile. In equities, valuation is in your favour but the price momentum is against you. Systematic Investment Plans (SIPs) in blue chip stocks or funds will be appropriate with an overweight allocation to equity at a Sensex valuation of 12 times one year forward earnings. The real estate sector is under stress with sales slowing down. One should look at joining hands with a group of buyers to get a good bargain. Gold is a better buy at $1,450-1,500 level than at current prices as the dollar is likely to strengthen in the near term.

In these circumstances, fixed income provides the most reassuring opportunity. The Reserve Bank of India (RBI) has announced a pause on rate hike as growth is slowing down faster than the fall in inflation. Liquidity at the beginning of 2012 is very tight and way above the RBI's corridor. The RBI is providing liquidity through various means including open market operations and liquidity adjustment facilities. Cash reserve ratio (CRR) cuts succeeded by repo rate cuts may happen towards the first half of 2012. All this is very conducive for interest rates to decline. Going long on duration or maturities will be rewarding for investors this year.











CASHING IN: In the medium-term, investing in bank deposits is a good option (Bloomberg)

Cash which is kept for day-to-day expenses or an emergency or pending deployment should be parked (not invested) in liquid and liquid-plus funds. They are giving very good returns, more than the returns on savings bank accounts.

In the short- to medium-term horizon of one-to-three years, one can build a portfolio of NBFC (Non Banking Finance Companies) bonds which came out with IPOs in 2011 and are currently available at very attractive yields in the secondary market. However, investors should ensure that their portfolio comprises of a few names rather than concentrating on only one company. Moreover, NBFCs should not exceed 10 to 15 per cent of the total portfolio. One can also look at investing in short-term funds which provide daily liquidity, sometimes after a lock in. As rates decline, such funds shall deliver returns through capital appreciation.

In the medium-term horizon of three to seven years, one can look at investing in bank deposits, PSU bonds, small-savings instruments such as National Saving Certificates (NSC), etc., or fixed income funds to earn high single digit interest. There is also a good chance of capital appreciation in bonds and debt funds. It will be fair to assume that most of these instruments at the end of 2012 will have a lower interest rate than at the beginning of 2012. Hence, one should invest as early as possible in these instruments. Bank fixed deposits and small savings are not tradable even though they have some overdraft or loan facility against them for liquidity.

PSU and corporate bonds have secondary market liquidity. Investors should only invest in investment-grade instruments and should not over expose themselves to one instrument. Fixed income funds come with tax advantages which may continue next year as the direct tax code (DTC) is unlikely to be made applicable in FY2013. In the first half of 2012, fixed income funds are better poised from a risk-return point of view, while in the second half equity funds are likely to be better poised.

In the medium-to long-term horizon of over seven to 10 years, one can look at investing in long-dated gilts (up to 30 years), PSU bonds, perpetual bonds of highly-rated companies and longer duration gilt funds. All these higher duration instruments will give good capital appreciation if interest rates decline as expected in 2012. It is worth applying for a longer-term bond even if your investment horizon is less as the declining rates will create capital appreciation when you want to sell them in the secondary market. Tax-free bonds are also available at attractive interest rates and are a good opportunity for those in the highest tax bracket.

However, investors should be cautious of taking credit risk in 2012. The global, as well as the local liquidity scenario is expected to be tight in the first half of 2012 and there are very high chances of stress emerging on many lower-rated and highly leveraged companies in 2012. In India, the ability as well as the willingness to pay by the borrower is critical in getting your money back. In the debt market, the returns are lower but at least one has the assurance of getting one's money back.

Many instruments with underlying security of real estate, property and shares are being made available in the primary as well as the secondary market at very high rates. It will be appropriate to remember that ‘there is no free lunch'. If these instruments are offering attractive yields then they must have higher credit risk. One should be very careful in investing in such instruments. Care should be taken limit such high-yield high-risk instruments on an individual basis (no more than 2 per cent) as well as on a portfolio basis (no more than 10 per cent). If the lead manager is sharing the co-investment risk, then it is a sign of reassurance.

Many structured products with pay off linked to index or basket of stocks are available in the market. These are highly specialised instruments. They have many fine prints and therefore should be looked at only after a proper understanding. Fixed income in 2012 is likely to reward higher duration/higher maturities and lower credit risk. Investors should practise asset allocation and regular investment. Discipline is the key to success.

Happy investing in 2012.

(This story was published in Businessworld Issue Dated 23-01-2012)