The big question now is: which way is inflation headed from now onwards? Says Indranil Sen Gupta, India economist, Bank of America Merrill Lynch: "Inflation is expected to fall for a few more months." The recent fall in wholesale and retail inflation is primarily due to the easing of vegetable prices. Since the latter is continuing to drop, so should inflation.
However, don't rush to celebrate yet because the fall may be a short-term phenomenon. The current dip in vegetable prices is due to the winter and may climb back at the onset of summer. The low base effect of April/May last year, when the wholesale inflation was below the 5% mark, is another reason inflation may rise. The wholesale debt market has already started celebrating the fall in inflation. For instance, the yield of the 10-year government of India papers has fallen to 8.64%, a two-and-a-half month low (see 10-year yield). "We see the 10-year yield coming down further to 8% in the next three to six months," says Gupta.
Here's a look at some investment products that can help you benefit.Long-term income and gilt funds
Since the price of debt papers and yield are inversely correlated, the recent yield fall has resulted in a rally of corporate debt/gilt papers. This is clearly visible in the NAVs of long-dated income and gilt funds. Most of them had given a 2-3% absolute return in the past month (see Top 5 tables). Since the yield is expected to fall further, shifting assets from short-term debt and liquid funds to long-term debt funds is a good strategy. If inflation rate, as well as interest rates, drop in the coming months as expected, investors in these long-term income and gilt funds stand to enjoy further gains.
However, financial planners advise not to go overboard with this strategy. To begin with, this is a high-risk, high-return strategy. Each of the one-month best performers have given paltry or even negative absolute returns in the past year when the interest rate rose.
If you choose to take this route, shift only a part of your portfolio. "Long duration funds should only form a small part of your portfolio," cautions Raghvendra Nath, managing director, Ladderup Wealth Management. This is because inflation is not the sole factor that decides interest rates. So, any untoward incident at a global level, say, a re-emergence of the debt crisis in Europe, can unsettle the applecart once again. Secondly, you need to stagger your investments. "The best strategy to invest in long duration funds at present is to do it in a phased manner till end-March," says Anil Rego, CEO, Right Horizons. Given that March is typically a month of tight liquidity due to the advance tax outflow and other year-end considerations, the yield may firm up once again during that period. Lastly, don't get carried away by short-term return possibilities and stick with the long-term view while investing in such high-risk products. "Though you can book profit if the interest rates fall significantly in the middle, the original investment horizon should be at least two years," adds Rego.
Tax-free bonds
The high-interest tax-free bond issues from government-sponsored entities are the best option at the moment. Since an 8.75% post-tax interest works out to 12.66% pre-tax interest for investors in the 30.9% bracket, this is a no-brainer. "This is also the best option for retired people since they can lock in at high tax-free rates for a very long time," says Rego. This explains why the Rs 2,100 crore NHB tax-free bond offering, which provided retail investors 9.01% on its 20-year paper, got oversubscribed on the first day itself. Though the rates have come down since then, both the issues that are currently available in the market—IRFC and NHAI—-offer good returns for 10-year and 15-year papers (neither player offers 20-year -papers). Though these are long-term investments, there is no lock-in period and are listed in the market. This means that it will also generate a short-term trading opportunity if the expected fall in interest rate continues. In fact, many of the recent issues are already quoting at a premium.
Should you pick the IRFC or NHAI? If you are a retail investor and want to put in only a small amount, go for NHAI because it is -offering better coupon rates. If you are a high net worth individual (HNI) and want to invest, say, Rs 20 lakh, invest equally in both offerings rather than going for NHAI alone because the rate on offer for HNIs is less by 25 basis points.
Bank FDs and fixed maturity plans
Fixed deposits are offering decent returns at present, but there is no reason to rush and park your funds here. The credit-to-deposit ratio is high for banks and they may try to corner more deposits by keeping the rates high. Taxation is another problem with FDs, especially for HNIs.
It is better to go for the tax-efficient fixed maturity plans (FMP) from mutual funds. The yield on one-year FMPs is around 9%, which is good to lock in at. However, FMPs are closed-ended products and only investors with holding power should get in.
Equity
This asset class also benefits from falling -interest rates. Firstly, it helps companies report a better profit since their interest burden reduces. The sale of several rate-sensitive sectors also picks up. Several stocks, such as banking, real estate, auto and capital goods, are picking up momentum after the drastic fall in inflation numbers. However, the Indian economy is going through a slow growth phase and, hence, getting into equity market only to benefit from the falling inflation and interest rates may be risky.
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