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By now, a regular reader of financial news and analysis would have tired of hearing clichés trying to explain the current stock market mess – “US heading for a recession”, “Rupee appreciation hitting exports”, “Valuations were getting extremely stretched and a correction was inevitable” and finally the solace - “Fundamentals and long term outlook for India remain strong”.

Now, perhaps understandably, you are wary of the 1-2 year outlook of the Indian stocks markets. At any rate, you hardly want to put all your eggs into this stock market today – since it has proved to no longer be the one-way (upward) street as in the last 4-5 years. Some of you have probably withdrawn part or all of the money in panic, at different phases of the current crash. Sitting on cash and reconciled to much more modest returns going forward, you wonder where to park the money over the next couple of years. There are a few interesting avenues you can still explore; and we will examine one of them in this article. In subsequent articles, we will look at other options to diversify risk without completely cutting off the potential for upside.

In a previous article, we had seen how debt is not always zero-risk or low return (refer - Debt means ‘No risk’ & ‘Low return’? Wrong on both counts!). Now, we use some of these debt instruments to try to generate additional return, while taking on a moderate additional risk (compared to fixed deposits).

An excursion into theory
Debt fund NAVs move in the opposite direction to interest rates. As seen in the accompanying table, periods of rising interest rates have seen debt funds languish, while they have done very well in falling (or low) interest rate environments. This has been in almost direct contrast to performance of the equity market.

In this article, we will not get into the technical aspects of this linkage. The only point to note is that there exists the ‘duration’ of any bond or debt fund. This is declared in all fund fact sheets on a monthly basis. The longer this ‘duration’, the more its NAV moves in response to interest rate movement. Thus, if one has a considered view on the interest rates, there are good investment options one can get into to benefit from the view.

Interest rate scenario
With increasing signs of weakness in the economy, the RBI is likely to take a more lenient view on the interest rates going forward. Banks have already started reducing interest rates on home and other loans. In short, there are reasons to believe that we are at or near the top of the interest rate cycle and should see rates falling over the next 2-3 years.

The investment strategy
Thus, given the theory background described above, an investment idea would be to go for long duration debt bonds. Almost all mutual funds (ICICI Prudential, HDFC, DSP Merrill Lynch, SBI Magnum, Reliance, etc) offer such products and some of them have minimum investment amounts as low as Rs. 5,000. If the interests do fall as expected in the next couple of years, returns of ~15%-17% are not unimaginable. Even if rates do not fall, the returns should be a more modest 6%-9%. In contrast, the stock markets could see even negative returns if the current weakness continues. (Check out - Top Performing Debt Funds)

The research you would need to carry out before investing would be to check the durations of various debt funds in the market. It would also be important to check the consistency of their investment philosophy, by looking at past duration numbers. Other factors like fund manager and fund performance may be examined. Once a fund has proved to have a consistently long duration portfolio, one can invest and hope for a falling interest rate scenario.

No returns without risk!
To be sure, this is not a risk-less strategy. What are the risks involved? For one, the RBI could decide that inflation is a bigger threat, and hence decide not to soften interest rates in the near future. It could even increase the Cash Reserve Ratio, or resort to other means to keep liquidity tight. This would hurt the returns on long duration debt bonds.

Also, if the weakness in the US turns out to be less than expected and the stock market rebounds, debt markets could underperform in comparison. It would also make you feel rather silly about having moved money out of equity at the wrong time.

Thus, it is important to diversify the portfolio – there is no need to completely exit equity; and certainly no need to put entire investment into debt funds. If you have an appropriate allocation to both, you might be in a position to enjoy the best of both worlds!

Source: Moneycontrol.com