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Monday, February 24, 2014

How to build Debt Portfolio?

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Choose Fixed Income Products not just for returns but the risk, liquidity and tax benefits



Fixed-income products are the cornerstone of an individual’s investment portfolio. When the going gets tough, investors seek comfort in fixed-income investments. Whether it is the humble bank fixed deposit, the PPF or a government bond, these provide stability to your portfolio. Any asset allocation plan is incomplete without a slice of fixed income, or debt investment. But even though safety comes first, investors should be mindful of a few key factors when developing their fixed-income portfolio:

Real Return

Don’t ignore the impact of inflation when considering debt investments. Even though an 8% return may appear decent, inflation is silently eroding that return. The real return often turns out to be poor or even negative. After considering the impact of taxes, the investor is often left with nothing. That is why it’s important to pay attention to real returns, rather than just nominal returns.

Default Risk


Certain debt instruments carry a default risk, meaning that the issuer of the instrument may not be in a position to return your principal at the time of maturity. While bank fixed deposits are nearly risk-free investments, others such as company fixed depositss, debentures and bonds are exposed to default risk.


Interest Rate Risk

If you invest in bonds or bond funds, you have to be mindful of the impact of interest rate movements on your investment. Bond prices move inversely to interest rates. So when rates rise, bond prices fall, which in turn brings down the NAVs of debt funds. Longer-tenure bonds are more sensitive to interest-rate changes than short-duration ones. It is advisable, therefore, to invest in longer-duration bonds if you expect interest rates to fall and avoid them when rates are expected to rise. Last week, when the RBI sprang a surprise and did not hike interest rates as was widely expected, bond yields crashed and the NAVs of debt funds shot up. If rates come down, debt funds give muted returns.


Where to Invest?

Fixed income as an asset class offers multiple options to the investor, each with its own unique features. The choice of product should depend on your risk appetite, liquidity needs, investment horizon and tax considerations. Be clear about what you want when you invest in debt. If you are looking for a regular stream of money and the preservation of capital, then a simple fixed deposit that pays interest every month or quarter makes sense. If you do not need the regular inflow and can keep the money tied up for a longer time, choose the cumulative option of the fixed deposit or go for NSCs. The PPF is a long-term investment that locks up your money for 15 years.


The tax incidence is also important. For those in the higher tax brackets, it makes more sense to invest in instruments that give higher post-tax returns (fixed maturity plans, debt funds, etc). Tax-free bonds also offer the chance to earn high interest income without any tax incidence. For those in the lowest tax bracket, investment in fixed deposits and recurring deposits is a good idea.

However, to get more out of fixed income, you will need to move a bit higher up the risk ladder. Bond funds and FMPs provide a good alternative to traditional instruments as they can offer decent capital appreciation, even though the returns are not guaranteed. Company fixed deposits and NCDs do offer higher return (double-digit, in most cases) than traditional fixed income instruments, but they carry much higher risk of default.


So, opt for these instruments only if you have the requisite risk appetite. Now, you can also opt for inflation-indexed bonds (that are linked to the Consumer Price Index). These bonds have an in-built mechanism to negate the impact of inflation on your income.

Happy Investing!!

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