Debt investments: A safer bet now?

In uncertain times everyone takes comfort with their best friends. Similar is the case with the investor community. Whenever market volatility increases, inflation raises its head, interest rates are rising and there is fear of economic down turn, focus of investors shift from capital appreciation to capital preservation. This is the time investors remember the old and trusted buddy "Debt Investment", whom they normally forget in good times. In this article we will try to understand why this instrument acts as a savior and find out the reason why it takes the back seat when the investor community is in a positive mood. We will also try to figure out when the right time to invest in debt instruments is and what are the options available with us.

Debt Instrument
A debt instrument is an asset that pays fixed returns over time. It has a fixed maturity period after that the investors can liquidate the asset and gets the principal with the remaining interest dues.
Debts are low risk, low return assets. The liquidity is low to medium.
There are many debt types available to investors to choose from.
a.       Fixed Deposits
b.      Debt Mutual Funds
c.       Bonds and Debentures
d.      Government managed saving schemes (NSC, KVP, PPF)

Debt Instrument — Savior in the time of market uncertainty
Whenever there is doubt regarding the economic growth, inflation is high, and interest rate is rising due to monetary tightening, equity valuation goes down as the expected returns from equity investment goes up in a increasing interest rate scenario and return from debt instruments becomes lucrative. As the interest rate is rising, so is the return from the debt instrument. Due to risk aversion investors with a low risk appetite prefer to invest in debt instruments. High risk appetite investors also get into capital preservation mode and reallocate funds towards debt instruments.
The best time to park your money in a debt instrument is at the peak of the interest rate cycle. We all know inflation is increasing day by day and RBI is trying to tame it by monetary tightening. The interest rates have been going up slowly since the last one year as the RBI is tightening the monetary policy. We have seen that RBI has increased interest rates 11 times in last 2 years.
There is also uncertainty about RBI's next move when they meet in this month (September, 2011). It's expected that RBI will increase rates further as till now it has not been able to contain inflation. Based on this assumption we will be somewhere near the peak interest rate scenario around November. So investors should start planning for investment as the risk reward ratio is going to be in favor of investors in another two months.
Choices available for investors
Despite low risk low return nature of debt investment, debts within their own set vary in risk and return. Government securities and bank deposits are almost risk free (let's ignore inflation and interest rate risk) while corporate debts are riskier. Let's take a look at the choices available to investors.
For investors with low risk appetite and long term investment horizon
As per new DTC which is expected to be implemented from April 2012, PPF investments will continue to be governed by EEE (Exempt, Exempt, Exempt) and not EET (Exempt, Exempt, Taxable) meaning investment, accumulation and withdrawal - all three related to this investment will be tax exempt. So investment in PPF is recommended if DTC implements this rule from 2012. Investment in PPF also acts as a tax saving instrument which adds to the overall return on investment. Government securities and schemes are other options for risk-averse investors.
For investors with moderate risk appetite and short term investment horizon
Investment in Debt Funds and FD is a good option for investors with short to medium term investment horizon. Debt funds invest in various types of debt securities and are professionally managed. Most of the debt funds are highly liquid so money can be parked in them for a short term. Once the economic condition improves and interest rate eases, this money can be reallocated to equity portfolio. If you as an investor simply want to sit and enjoy life till normalcy in market returns then medium term FD can be a very good option for you as the return on them is attractive too.
A note on Direct Tax Code (DTC)
The direct tax code is expected to take out various debt instruments available to investors for tax saving purpose. Investment in Government managed saving schemes (NSC etc.) and infrastructure bonds for tax saving purpose are a strict no for the time being as upcoming DTC proposes to remove them from the categories of exempted income. Investors should wait for the clarity in DTC before they invest in them for tax saving purposes.