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Debt returns overshadow equity lure

business Updated: Mar 19, 2007 11:32 IST

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With experts forecasting a lower return from equity markets in 2007-08 and rising interest rates exacerbating the outlook of a lackluster market, it is time for you to take a re-look at your asset allocation.

Analysts expect the Sensex to give a return of 15 to 20 per cent in the current year, substantially low from the 40 per cent-plus returns it has delivered since 2003. While rising interest rates could dent corporate profitability to some extent, improving bond yields narrows down the premium one gets for taking the risk of investing in equities to that of in safer assets like bonds.

For example, if equity gives a return of 40 per cent and the risk-free interest rate stands at 5 per cent, an investor gets a 35 per cent premium for investing in stocks. However, with the benchmark yield on 10-year federal bond hovering around 8 per cent, the equity-risk premium shrinks to a meager 7 per cent, considering the Sensex delivers a return of 15 per cent.

"It is time for one to reduce the exposure to equity increase that to debt. Return from equity is expected to be considerably low compared to previous years. Meanwhile, interest rates are going up and that makes debt instruments more attractive," says Sundararajan, a financial planner.

Conventional wisdom has it that 100 minus a person's age should be the percentage of his investments in the stock markets, with a 5 per cent adjustment factor, as per the market conditions. In other words, a 25-year-old should invest 75 per cent of his portfolio in the stock markets and the balance in safer asset classes. Factoring in the 5 per cent risk adjustment factor, this 75 per cent could go up to 80, under good market conditions, and down to 70, if otherwise.

Under the current circumstance, this 5 per cent adjustment factor, one has fair reasons to believe, needs be deducted from the percentage exposure in equities.

Thus said, fixed maturity plans (FMPs) of mutual funds seem to be an attractive asset class. FMPs are mutual fund schemes that invest entire corpus in financial instruments that mature on a pre-mentioned day.

"Many FMPs have started delivering returns of around 10 to 15 per cent which mature between 12 to 15 months, with benefits of indexation," he says.

The benefit of indexation offers the investor an option to factor out the effect of inflation on his investments and pay tax on the actual profit.

So 2007-08, it seems, is rather the time to park your funds in FMPs and sleep peacefully than scurry in the dark worrying which way the markets will throw you.