DEBT MFs – A critical portfolio ingredient

D EEPAK KHANDELWAL, 35, has been investing in mutual fund schemes since the last seven years. Every month he in vests an equal amount in debt as well as equity mutual fund schemes. Over the years, the monthly investment amounts have increased periodically with the increase in his salary and investible surplus. Deepak has discovered that by investing systematically he has been able to build up a sizeable corpus. He observed that the debt component of his portfolio seems to be more stable than his equity component, which tends to be more volatile. He also observed that at times when equities were not delivering high returns, debt mutual fund schemes generated high double-digit returns.

Investments in debt mutual fund schemes provide stability to the portfolio and are great tools for hedging the risk of equity markets. The returns from any asset class can be broken down into:

a) Regular income in the form of interest (in the case of debt) and dividend (in the case of equities) b) Increase in the price of the asset, which is called capital appreciation In the case of debt investment, there is an element of regular interest income, which ensures that returns from debt schemes are almost stable.

The prices of debt instruments may go up, if interest rates go down, adding to the overall returns by way of capital gains over and above regular interest income. Conversely, if interest rates go up, prices of debt securities go down, eating away the returns generated by interest income.

As compared to equity schemes, it has been observed that return from debt schemes are more stable since:

Regular income in the form of interest, comprises a major component of debt returns Incidence of capital gains is lower in the case of returns from debt Dividend yield from equity is low Capital gains form a major component of equity returns.

Another interesting aspect of debt investments is that they tend to generate high returns at times when equities are unable to perform well. For an investor who is well diversified, returns from debt schemes could compensate him/her for the lack of returns or negative returns from equities during certain periods.

When an economy is not growing or is facing a recession, the profitability of companies comes under pressure and the equity returns turn flat to negative.

Among other factors, in order to spur consumption and investment demand, the monetary authorities bring interest rates down.

It becomes easier for people to finance their expenditure leading to an increase in the overall demand for goods and services in the economy. Lower interest rates lead to high debt prices and translate into higher returns for debt investors.

When equities under-perform, debt returns tend to be high and compensate for lower returns from equities.

That is why investors are advised to keep at least 25 per cent of his/her investments in debt, including mutual funds, and ramp it up to 75 per cent during periods of higher volatility in equity markets, or when a rise is uncertain.

If we look at Deepak’s returns chart, we can clearly see that debt has played its role by providing stability to his overall portfolio. Returns from his debt investments have been less volatile than those from his equity investments and has resulted in an overall 10 per cent yearly gain over the years. In 2001 and 2002, when equity markets were in the doldrums, debt investments generated 17 per cent, thereby buoying overall portfolio returns.

In 2003, equities rallied smartly, while debt posted strong returns.

In 2004-2005, capital losses reduced debt fund returns, while equity performance was boosted by capital gains. All in all, it has been a wise investment strategy that has paid off for Deepak. Above all, one has to keep the applicability of capital gains tax to debt mutual funds.

In summary, since it is difficult for even seasoned experts to predict economic cycles and it has been observed that debt returns outperform equity returns in periods of economic downturns, it is a prudent strategy to allocate part of your investible surplus regularly to debt schemes, which provide relatively stable returns and act as an effective hedge to your equity portfolios.

(The author is Head-Fixed Income, Princi pal PNB Asset Management. The views many not represent that of his employer) How they Returns (%) Equities Debt Overall 2001 -43 17 -13 2002 -2 17 8 2003 72 9 41 2004 25 1 13 2005 38 5 22 2006 38 8 23 Average 21 10 15 Note: Hypothetical statistics for illustration purpose only.
D EEPAK KHANDELWAL, 35, has been investing in mutual fund schemes since the last seven years. Every month he in- vests an equal amount in debt as well as eq- uity mutual fund schemes. Over the years, the monthly investment amounts have in- creased periodically with the increase in his salary and investible surplus. Deepak has discovered that by investing systematically he has been able to build up a sizeable cor- pus. He observed that the debt component of his portfolio seems to be more stable than his equity component, which tends to be more volatile. He also observed that at times when equities were not delivering high returns, debt mutual fund schemes generated high double-digit returns. Investments in debt mutual fund schemes provide stability to the portfolio and are great tools for hedging the risk of equity markets. The returns from any asset class can be broken down into: a) Regular income in the form of interest (in the case of debt) and dividend (in the case of equities) b) Increase in the price of the asset, which is called capital appreciation In the case of debt investment, there is an element of regular interest income, which ensures that returns from debt schemes are almost stable. The prices of debt instruments may go up, if interest rates go down, adding to the over- all returns by way of capital gains over and above regular interest income. Conversely, if interest rates go up, prices of debt securities go down, eating away the returns generated by interest income. As compared to equity schemes, it has been observed that return from debt schemes are more stable since: Regular income in the form of interest, comprises a major component of debt re- turns Incidence of capital gains is lower in the case of returns from debt Dividend yield from equity is low Capital gains form a major component of equity returns. Another interesting aspect of debt invest- ments is that they tend to generate high re- turns at times when equities are unable to perform well. For an investor who is well di- versified, returns from debt schemes could compensate him/her for the lack of returns or negative returns from equities during cer- tain periods. When an economy is not growing or is fac- ing a recession, the profitability of compa- nies comes under pressure and the equity re- turns turn flat to negative. Among other factors, in order to spur con- sumption and investment demand, the monetary authorities bring interest rates down. It becomes easier for people to finance their expenditure leading to an increase in the overall demand for goods and services in the economy. Lower interest rates lead to high debt prices and translate into higher re- turns for debt investors. When equities under-perform, debt re- turns tend to be high and compensate for lower returns from equities. That is why investors are advised to keep at least 25 per cent of his/her investments in debt, including mutual funds, and ramp it up to 75 per cent during periods of higher volatility in equity markets, or when a rise is uncertain. If we look at Deepak’s returns chart, we can clearly see that debt has played its role by providing stability to his overall portfolio. Returns from his debt investments have been less volatile than those from his equity in- vestments and has resulted in an overall 10 per cent yearly gain over the years. In 2001 and 2002, when equity markets were in the doldrums, debt investments generated 17 per cent, thereby buoying overall portfolio re- turns. In 2003, equities rallied smartly, while debt posted strong returns. In 2004-2005, capital losses reduced debt fund returns, while equity performance was boosted by capital gains. All in all, it has been a wise investment strategy that has paid off for Deepak. Above all, one has to keep the applicability of capital gains tax to debt mutual funds. In summary, since it is difficult for even seasoned experts to predict economic cycles and it has been observed that debt returns outperform equity returns in periods of eco- nomic downturns, it is a prudent strategy to allocate part of your investible surplus reg- ularly to debt schemes, which provide rela- tively stable returns and act as an effective hedge to your equity portfolios. (The author is Head-Fixed Income, Princi- pal PNB Asset Management. The views many not represent that of his employer) How they Returns (%) Equities Debt Overall 2001 -43 17 -13 2002 -2 17 8 2003 72 9 41 2004 25 1 13 2005 38 5 22 2006 38 8 23 Average 21 10 15 Note: Hypothetical statistics for illustration purpose only.