The changing landscape of debt investments

While all the noise and excitement is normally about the stock markets, I think it will be fair to say that most investors in India historically have always depended on debt for their short and long term investments. Whether you look at the number of investors or at the financial assets invested, this conclusion is an inescapable one. Even for investors focused on equity, the almost automatic investments in FD, RD, PPF / NSC and of course PF is a reality. This is also a good thing as I am a staunch believer in having a solid bedrock of debt investments for giving stability to any portfolio.

In the present investment climate of India, the significant changes that are happening to the debt instruments and their potential returns have almost gone unnoticed. It is important to understand the changes to the landscape and more importantly, what will be the impact on the investors who are investing primarily in debt instruments. Before we look at the various classes of instruments, we need to understand the main reasons for the changing scenario.

As most of us know, returns from debt instruments have always been closely linked to the prevailing inflation rates in the country. Obviously, if the inflation is high the returns from such instruments also needed to be high, in order to remain attractive for people to invest in them. While inflation figures and interest rates have fluctuated over the last few decades, in general they have remained high. I remember the PPF rates used to be 12 % when I started investing in it more than 20 years back and went down to 8 % at it’s lowest point. Interestingly our financial institutions are quicker in lowering rates when needed and quite sluggish in raising it when the inflation gets higher.

Now all high inflation economies will get control over inflation as time goes by. Developed nations have lower inflation and going forward it is quite possible that we will be looking at inflation rates lower than 5 % before long. As the RBI Governor has signaled, it is going to work in closer coordination with the government on the policy rates. This essentially means the returns from debt instruments are going to change. What is more, with inflation being tamed, the changes in the returns may well be more permanent in nature than what we have seen earlier.

Bank FD s are always the first product to have the rates revised and this has already happened. Most banks are offering rates lower than 7.5 % now and even for senior citizens the highest rates available is 8.4 %. My parents have some FD s started a year back and they were getting 9.5 % in those. It is quite possible that over the next year, as policy rates go even lower with inflation declining, the FD rates will drop to below 7 %. This will be quite significant as I cannot remember the last time when these rates were below 7 %.

The other important impact will of course, be on the rates of the small savings schemes such as PPF , POMIS etc. The RBI has recommended that returns from such schemes be aligned to the bank interest rates. While this will be politically a tough thing to carry out immediately, over a period of time this conclusion is an inevitable one. The PF rates again will quite possibly be revised downwards, though even here it will be a difficult decision to implement.

What about debt mutual funds? Well here, the returns impact will depend on the type of funds we are talking about. Liquid funds and MIP etc will have lower returns. Investing in FMP seems to have very little point now. Gilt funds and other debt funds will have higher returns in a declining interest rate cycle and they can be invested in. However, with lower inflation we will also have a dampening effect on the Cost Inflation Index. This will essentially mean that the effective taxation on the capital gains will be more when you redeem your debt funds. This is too complex to explain in the context of this post, I hope to write a post on this later in the week.

The above would have shown you that there aren’t a whole lot of options as far as decent returns from debt instruments are  concerned. What should be the debt strategy then? Let me write about this in my next post.