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Five money-making instruments in a rising interest-rate environment

The Reserve Bank of India (RBI) recently hiked the repo rate to 6.50 per cent. Even after two successive rate hikes, economists expect that there may be more in the future and the trend of rising rates may continue for another 12-18 months. While rising rates will hurt borrowers, fixed-income investors stand to benefit. However, they must invest in the right products and exercise some precautions.


Fixed deposits (FDs): Rates offered by this perennial favourite of conservative investors are on the upswing. The State Bank of India hiked its retail deposit rates recently (the one year rate is now at 6.70 per cent, 7.20 per cent for senior citizens).  Financial planners expect FD rates to rise further and hence suggest that you should invest in shorter-duration FDs of around six months at present. This will allow you to roll over to higher rates later. Also, some banks offer much higher rates than the bigger, more established ones. For the sake of safety, stick to the larger commercial banks and invest only a small portion of your corpus in other banks offering above-average rates.


Shorter-term debt funds: Debt fund investors should avoid all longer-duration funds and stick to those with shorter durations, such as liquid, ultra-short duration, low-duration, money market and short-duration funds. These funds are less sensitive to interest rate hikes than their longer-duration counterparts. If you have to choose a fund from these categories, the thumb rule is to have an investment horizon equal to or slightly higher than the average duration of the fund category.


Financial planners say that in India, shorter-duration debt funds can form a substantial portion of the investor's debt fund portfolio under all interest-rate conditions. "In India, the yield curve is not very steep, so you don't get too much premium for taking a high-duration risk. The difference in the long-term returns of shorter-term bond funds and longer-term bond funds is not much (See 10-year returns in table). So why opt for more volatile funds if you are going to get a similar level of returns," says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA).


Even among shorter-duration funds, the most risk-averse investors can get by with just investing in liquid funds. "The difference in the returns of a liquid fund and a short-duration fund will not be more than 50-60 basis points (bps). So conservative investors can manage by investing in the simplest, safest and most liquid category in this volatile interest-rate scenario," says Nikhil Banerjee, co-founder, Mintwalk.


When selecting a fund from a particular category, make sure that the return is in line with the category average. If it is above average, it is likely that those returns are being generated by taking credit risk, that is, by investing in lower credit quality paper. "By investing in a shorter-term debt fund, you can take care of duration risk. While Sebi has put a cap on how much duration risk these funds can take, it has not stipulated how much credit risk they can take. That is something the investor has to watch out for himself," says Raghaw. Some funds stipulate in their scheme information document (SID) how much credit risk they will take, but most don't. Make sure that the larger portion of the fund's portfolio is invested in triple-A or P-1 plus (the highest rating for commercial papers) instruments. Check the fund's portfolio quality on the website of a rating agency such as Morningstar or Value Research.


One category of funds where the investor gets both low duration and assurance regarding credit quality is money market funds. "These funds can invest in instruments of up to a year's duration. And they have to invest in money-market instruments. Only good-quality corporates can access money markets, so you are assured about credit quality also in these funds," says Raghaw.


As for all debt funds, make sure that the expense ratio of the shorter-term debt fund you invest in is low.


Credit risk funds: These funds try to generate higher returns by investing in lower-rated debt papers. They also invest in instruments that have a lower rating currently, but which may get upgraded soon (so that the price of the bond appreciates). While corporate bond funds have to invest at least 65 per cent of their portfolio in AA and above rated securities, credit risk funds have to invest at least 65 per cent of their portfolio in below AAA-rated securities. Apart from the risk of default, lower-rated papers also carry higher liquidity risk, making exits from them in case of an adverse development difficult. Only seasoned investors who understand their higher risk should invest in these funds. 


To curtail risk, investors should have only limited exposure to these funds. "If 70-80 per cent of an investor's exposure is in shorter-duration funds, he can take 15-20 per cent exposure in credit risk funds," says Banerjee. He suggests going with an experienced manager having at least 10 years' experience in managing debt funds.


Raghaw suggests investing in a fund with assets under management (AUM) of at least Rs 80-100 billion. "A bigger-sized fund is likely to be more diversified and have at least 25-50 bonds in its portfolio. In case one bond defaults, the damage is likely to be limited," says Raghaw.


Fixed maturity plans (FMPs): FMPs allow investors to lock into the current rate of return. The investor roughly knows the rate of return he is likely to earn when the FMP matures. He is thus able to avoid the volatility that he would be subject to in an open-end debt fund.


The disadvantage of these funds is that the investor has to sacrifice liquidity. If he is in need of money and wants to exit, he will have to sell them in the secondary market, where liquidity is low. He may face difficulty in finding a buyer or may have to sell at a discount. "The investor ends up sacrificing liquidity for almost nothing. He could get similar returns by investing in an open-end short-term debt fund of a similar tenure where the level of volatility is anyway low," says Raghaw. In FMPs, again, investors have to be wary about credit risk. "To generate higher returns, the fund manager may invest in lower-rated securities," says Banerjee. Avoid FMPs that will invest in lower than AA-plus rated papers.


Non-convertible debentures (NCDs): A number of NCDs, such as those from Shriram Transport and ECL Finance (the non-banking arm of Edelweiss), have hit the markets in recent times, promising returns of over nine per cent. NCDs too allow investors to lock into attractive rates of return. However, unlike in a debt fund, there is no fund manager here, so the investor must do the due diligence on credit quality himself. Again, do not invest in papers of below AA-plus rating. Also, stick to well-known names that have a long history of having raised money through NCDs and of having repaid investors. Experts suggest that investors would be better off investing in an FMP, where they can also lock the interest rate, because there the credit risk is more diversified. NCDs also suffer from the same liquidity issues that FMPs face. Investors should have only a limited exposure to FMPs and NCDs in their debt portfolio.