Debt or equity

The question as to where to invest — in debt or equity — is not about which asset class is more attractive, but about how to allocate between the two if you have a specific purpose in mind. Depending on the individual’s circumstances, resources, aspirations, investment horizon and risk tolerance, one needs to arrive at the proportion between debt and equity.


Why debt


Investors typically end up investing in debt investments to seek capital protection, have a predictable income stream and low overall portfolio fluctuation. Let’s say, you were an avid debt investor in fixed deposits of venerable banks like the State Bank of India. A decade ago, if you had lent money through a deposit to SBI for a period of ten years and renewed it at prevailing rates, a lakh of rupees earning 7.6 per cent per annum would have grown to roughly Rs 2.1 lakh today, provided you didn’t have to withdraw money or pay taxes. In case you saved the money for general purposes, the sum you saved may not buy much more than it did at that time. What went wrong? Nothing really.

While your deposit was earning interest, the value of the investment was being stolen away from you silently by the dangerous destroyer of wealth called inflation. It took away 5.1 per cent a year, netting you just about 2.5 per cent as the “real” return.

In case you saved towards building a house, after a decade, you may not even have enough money for the kitchen, leave alone a complete house! After all, property prices have risen roughly at 12-15 per cent in the last 10 years, much more than what you earned on your FD.

Let’s say instead of lending to SBI you invested in their stock, by buying their shares for Rs.1 lakh, the value of your investment would be worth Rs.8.24 lakh at current market prices. Your decision would have been severely tested many times in between. When market was fearful it may have valued the company less than its worth and in generous times, much more than the fair value. But in the long run, it would have ended up valuing your partnership closer to the fair value. This example clearly shows that the decision between debt and equity should be based on what you saved for originally and for how long can you continue to stay invested.


Which debt options


The choices within debt may change depending on the direction of interest rates. For now, the probability of the overall domestic economy picking up well is likely to cap the fall in interest rates. Interest rate-sensitive bond funds and gilt funds in such a case will struggle to deliver out performance. Retail deposit rates are continuing to fall while the rates prevalent in the larger debt market have been picking steadily since January this year. This leaves a retail debt investor in a Catch-22 situation — with neither attractive rates from a fixed deposit nor the certainty of higher returns from income funds.

If one were to lock-in the money in long-term deposits, one may regret the decision as inflation tends to rob the value of the investment. One can alternatively invest in Arbitrage Funds and Monthly Income Plans which are conservatively managed and can give a decent hedge with a small percentage of equity built in.

As to long-term surpluses that may not be required at the next four-five years, one can invest in equity comfortably. Valuations aren’t as cheap as they were about even four months back.

In a growing economy like India, which is one of the most broadbased in the world, one is better off investing in a diverse set of sectors either directly or through a mutual fund. Which sector will be more valuable in the short term in terms of appreciation of market value is a difficult guess. The world is waiting desperately for clear signs of revival and if evidence to the contrary emerges, there may be another bout of short term pain. Hence it’s better to stay diversified rather than taking sectoral bets.

Yet, in the long run, say two-three years, almost all real asset prices, equity, commodities, real estate may appreciate so much to balance the deterioration of the paper currency that buys them. The amount of stimulus and the potential circulation of money itself may guarantee that the real assets will appreciate strongly. If this unfolds, paper money and fixed income options make may look like one big mistake.