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For investors who count on term instruments to bring in regular income, the rate hike uncertainty makes life difficult.

People who depend on interest income from fixed-income instruments to meet their day-to-day expenses are a worried lot. Even though they keep hearing of an imminent tightening of rates by RBI, bank fixed deposit rates have not moved much. Should you opt for a 7% one-year fixed deposit offered by banks, or for a three-year non-convertible debenture (NCD) that offers returns in excess of 10%; or, should you consider investing in the debt mutual fund space? The rising uncertainty in equity markets further adds to the confusion, as portfolio returns depend on stability, traditionally afforded by fixed-income instruments.

BANK FIXED DEPOSITS

This is probably one of the most popular investment avenues among local investors due to the safety, liquidity and ease of operations it offers. You can walk down to your neighbourhood bank branch and open a fixed deposit (FD) with it. A look at the rates on one- to two-year FDs by nationalised banks reveals that investors are unlikely to earn more than 7-8% per annum before tax. If you fall in the highest tax bracket, the post-tax returns stand reduced by 30%. If you are not comfortable with any other product but a bank FD, you may choose to go with a one-year fixed deposit, with an opportunity to renew it after its tenure at a higher rate of interest. If you are willing to put in some effort, consider going in for a shorter-term deposit of six months offering a 5-5.5% returns per year, with a hope that by the time the deposit matures, the interest rate offered by the one- to twoyear tenure FDs moves up.

COMPANY FIXED DEPOSITS

A quest for higher returns draws investors to company FDs. The range of returns in this space is rather high. It starts around 8% and at the higher end quotes at 11%. But investors have to be very careful while taking a pick. High returns come with higher risks. So, take the trouble of checking the company's credit rating. Stick with known names, even though it means lower returns. It will be better if you check the company's pre-mature withdrawal norms.

NON-CONVERTIBLE DEBENTURES

There has been a mad rush of late among investors for such instruments. The recent NCD issue from Shriram Transport Finance was oversubscribed within two days of opening and the issuer had to close it before the last date (May 31). Along with the higher rate of interest, investors are also drawn to NCDs as there is no tax deducted at source on the coupon. However, investors should understand the higher risk associated with the instrument. "Compare the yields with risk-free rates and yields offered by financially strong borrowers. Disproportionate credit risk should be avoided for extra returns," says Devendra Nevgi, founder and principal partner, Delta Global Partners.

Debentures typically have a five-year term, with many of them having put/call options at the end of three years. Though investors can sell the debentures on stock exchanges, a rise in interest rates, if it happens, exposes the investors to rate risk. Debentures reward investors with a fixed coupon and the interest is subject to the marginal rate of tax. Considering that post-tax returns on NCDs are similar to company FDs, higher post-tax returns on mutual funds have a greater pull for investors.

FIXED-INCOME INSTRUMENTS VIA MFs

An investment in fixed-income instruments through the mutual funds route gives an investor a basic understanding of interest rate movements. The 10-year government paper's benchmark yield has fallen from above 8% to 7.6%. As the government is set to receive Rs 67,720 crore from the 3G spectrum auction to telecom companies, the fiscal deficit stands reduced. As far as the monsoon goes, there is no bad news so far on that front - a good monsoon is a precursor to low food inflation. Also, the clouds of crisis that have gathered over Europe have a silver lining in the form of lower commodity prices as a result of weak sentiment. This could bring down inflation, which, in turn, can reduce the rates at the long end of the yield curve over the next six months.

"A fixed-income investor with a 2-3 year horizon can consider medium-term income funds for reasonable returns," says Mr Nevgi. The risk-reward proposition is surely as not as attractive as it was when the 10-year yield was quoting above 8%. At the shorter end of the yield curve, however, RBI rate action is going to be the deciding factor. The speed of a rate hike is expected to be low, given the liquidity crunch in the domestic economy and credit crisis in Europe. "Short-term income funds look good for investors with less than a one-year time frame. In short-term fixed maturity plan, investors can make the best of the opportunities available in first week of June," advises Ritesh Jain, head- fixed income, Canara Robeco Mutual Fund.

This is the time when the investors will be better off taking into account a portfolio approach to their investments. Emergency funds can ideally be parked in the liquid plus funds. For less than a one-year tenure, the best bet will be short-term bond funds or short-term floating rate funds. But those who are looking at longer tenures will be better off with medium-term income funds.

Source : http://epaper.timesofindia.com/