fjrigjwwe9r1tblblogs:content The four and a half month period since Diwali has been tough on investors with both debt and equity performing much below their potential. Only Cash and Gold stood out as performers with the former giving annualised returns in the range of 7.5-8% p.a. and the latter delivering absolute returns of 5%. During this period, stocks (represented by the BSE Sensex) went down by more than 17%, long term interest rates (represented by 10 yr g-sec yield) moved up from 8.02% levels to 8.25% levels leading to a downside in long term bonds and short term interest rates (represented by one year bank CD rates) moved up from 8.6% levels to 10.25% resulting in a fall in prices of short term debt instruments. On the contrary, this period also saw Gold move up by 5% from Rs. 19970 to Rs. 20975 whilst money market instruments gave returns in the range of 7.5% to 8.0%.
For stock markets, sentiments turned upside down during the last 4-5 months as compared to those prevailing during the preceding 5 months from June 2010 to October 2010. Whereas, during the period between June-Oct 2010, the markets ignored factors such as high inflation and potentially high interest rates, European Debt crisis, rising commodity prices and high valuations, all these fears came back to haunt them in the period after the festive season. Inflation continued to rage higher, driven by stubbornly high prices of food and non-food primary articles and higher energy prices. It was just a matter of time before the high primary article inflation spilled over into higher wage and manufactured goods inflation, the markets thought. Interest rates shot up higher as the banking system struggling to mobilise deposits at the then prevailing rates, started hiking deposit rates and short term interest rates moved up sharply even though longer term interest rates remained range bound due to Central Bank intervention. Liquidity tightened severely as currency in circulation rose, people started investing in gold and government slowed down spending following a spate of scams. As a consequence, equities started getting de-rated with the Sensex one year forward PE falling from 18 times to 15 times within the span of 3-4 months.
Bonds also suffered as interest rates rose sharply, leading to below par returns on market linked bond funds. Asset allocation funds including hybrid funds such as Monthly Income Plans (MIPs) and Balanced Funds were the worst hit as they lost money on both portions of their portfolio – equity and debt. During this period, a lot of money moved from capital markets to bank fixed deposits as suddenly, bank deposits of tenure one year or more, that were earlier yielding 7-7.5% p.a. started yielding more than 9% p.a.
Once bitten twice shy: Hit hard by both debt and equity, investors were lured by the seemingly irresistible safety and high pre-tax returns of bank fixed deposits. Nobody even cared to think that post tax returns from bank deposits, working out to 6.3% p.a. (at 9% pre-tax yield and for an individual falling in the highest tax bracket) even now won't be sufficient to negate the impact of inflation which continued to hover above the 8% mark. The other flip side of bank fixed deposits is that they do not provide any scope for growth. Though one is assured of getting the promised rate of return, it will never be higher than what was promised. The impact is not felt in the short term, but in the medium to long term, when one finds that the post-tax returns from his/her bank deposit have been peanuts as compared to what he/she could have made by investing in stock markets or any other growth asset during the period.
Risk and return go hand in hand. Low risk invariably means comparably lower returns. This is a universal truth. One cannot detach risk from return. Efforts to detach the two have failed horribly as seen most recently in 2008. When one opts for safety, he/she is losing out on potentially higher growth.
The biggest challenge for an investor today is to get his investment returns beat inflation without taking the risk of losing out on capital. It is all the more daunting in the current scenario when inflation is so high that it has started affecting both equities and debt. Research shows that when inflation rises above a certain level, it starts affecting both equities and debt. Deflation is bearish for equities but bullish for bonds. Reflation and low inflation are bullish for equities and bearish for bonds. But high inflation is bearish both for equities as well as bonds.
In this background, we need to find an investment solution that can possibly give double digit returns with safety of capital. Monthly Income Plans or MIPs could have been a good option, but they are vulnerable to interest rate risk as has been seen in the recent past. We thus need a product that can benefit from the prevailing high yields at the shorter end of the curve as well as provide some scope for capital appreciation by investing in a growth asset class.
A recent innovation by the Mutual Fund Industry called "Capital Protection Oriented Funds" (CPOF) serves this purpose. CPOF is a close-ended product that invests in a portolio of debt market and equities.
Insulation from Interest Rate Risk - Investments in the debt portfolio are made in high grade debt papers maturing on or before the date of maturity of the scheme. Debt papers are thus held till maturity eliminating the risk of mark to market losses due to interest rate movements. This is particularly attractive in the current scenario when short term rates are in double digits.
Endeavor to Protect Capital - The principal invested in debt papers is such that the amount available at the time of maturity at the given coupon rates is equal or more than the original amount invested in the scheme. For instance, out of Rs. 100 invested in the scheme, the fund may invest anything between Rs. 75-85 or even more in debt papers carrying coupon so that the amount received from this investment at the time of maturity of the scheme is at least Rs. 100 or more. Since, the debt part is invested in very high quality papers (AAA rated), the credit risk is low and hence chances of ca |