More often than not, we end up putting funds available for low-risk investments into fixed deposits with banks or in government small savings schemes, some of which may even have tax benefits.
Given the conservative approach of Indian investors, a large part of their investments comprises debt or fixed income products. It, therefore, becomes important to understand what the options are. The debt markets are not limited to just fixed deposits, giving investors many other choices. While equity mutual funds have many advantages, debt oriented mutual fund schemes are more important as there are many investment alternatives like Commercial Papers, Corporate Bonds etc. that are not directly available to individual investors. This is primarily because such products deal in minimum ticket sizes of Rs 5 crore and are more suited for institutional investment.
When we invest in a fixed deposit, we continue to get the annual rate of interest promised for the term of the deposit and do not care about whether interest rates are rising or falling. This is because a fixed deposit is not tradable. It will either mature or you will break the fixed deposit before maturity. However, conceptually, changes in interest rates impact all investments including these fixed deposits. Take for example, you place a 5-year deposit of Rs 1 lakh with a bank at an interest rate of 7%. If after six months, the bank revises upwards the rate on 5-year fixed deposits to 8%, you now have an opportunity cost of 1% for the next 4.5 years. If the money was not already invested at 7%, you could have invested it today at 8%. Also, no one will buy your deposit at 7% because they can place a fresh deposit at 8%.
Therefore, if you need to sell the deposit, you will have to reduce the amount that you will take from the buyer so that s/he get a rate of 8% on their investment for the remaining 4.5 years. Thus, you will notice that as interest rates rise in the markets, the value of your existing deposits/investments declines. The converse is also true.
Debt oriented mutual funds pool together smaller investments made by a large number of investors and are able to participate in the institutional market. They, therefore, can buy and sell all the available debt instruments. Most of these instruments are tradable and the ups and downs of the price of individual securities determine the change in the net asset value of these schemes on a daily basis.
Overnight Funds, Liquid Funds, Ultra Short term Funds, Short Term Funds are short maturity bonds (like short term deposits).
Bond Funds and Income Funds hold longer maturity bonds and G Sec Funds probably have the longest
maturity of the investments. It is important to know the maturity profile of the scheme that you are invested /intend to invest into. Once you are broadly aware of the maturity profile of various schemes, the even more important factor is to determine whether interest rates are expected to go up or down in the future. There are hundreds of factors that impact interest rates and one can only estimate how rates will move going forward.Based on this, you can choose short term products if rates are expected to go up, or longer term products if interest rates are expected to decline in the future.
Interest rates in India have been on a low for quite a while now, but it is anticipated that they will move up from the current levels.
(The author is the founder of Five Rivers Portfolio Managers and can be reached at pankaj@5riversindia.com)