Given high equity valuations, debt a better option now

Debt funds dealing with instruments in 30-90 day timeframe would also be attractive

The website of IDFC Mutual Fund runs an interesting page, titled "Is it a good time to invest?" . This page claims that 80 per cent of investors make below average returns because they invest when the market is highly priced with a 3 year to 5 year horizon.  

The page uses BSE Sensex PE data to show the returns investors received in a given timeframe at a given valuation. For example, investors who entered when the Sensex was at a PE of less than 16 saw the index had averaged historic returns of -2.5 per cent in the past year. However, investors at below 16 PE received an average CAGR (compounded annual growth rate) of 29 per cent over a 3-year period and an average CAGR of 18 per cent over a 10-year period.

In contrast, investors who entered at above 20 PE, were presumably tempted since they were looking at a historic one-year return of 30 per cent. However, their 3-year return was only 3.3 per cent CAGR, while the 5-year return was about eight per cent CAGR. The 10-year return was a respectable 14 per cent CAGR.

The website makes a simple suggestion. An investor who enters at a PE of above 20 should only deploy funds which can be invested over a 10-year horizon. This has interesting implications.  Right now, the Sensex is at PE 20-plus. By this rule, an investor will only put very long-term funds into equity. This means the investor is deploying a smaller proportion of his or her savings. Hence, a larger proportion of savings must be deployed in other assets.

The advice in itself is sensible and data-driven. Investing at a high valuation makes it much more likely that there will be poor short-term returns. Only over a longer time period, will that return rise to respectable levels.  However, what should the investor do with the surplus savings, which he would like to park for some return with a 3-5 year horizon? Such a timeframe eliminates investments in real estate. The only realistic option is debt.

Now there are times when debt is objectively attractive as an asset-class and times when it is not. Sometimes equity may be high-valued but debt may also be unattractive. There are many types of debt instruments with different risk / return profiles and different timeframes. Making good choices with debt may be quite as hard (or even harder) than making equity picks.

At the moment, a very large proportion of traders are hoping for rate cuts. Anecdotally, there is a strong push for lower rates in the Ministry of Finance as well. Now that a Monetary Policy Committee with strong government representation is taking charge and the strongminded Raghuram Rajan is on his way out, lower rates are indeed likely. (They might be a bad idea, however.)

Under those circumstances, any entity with an existing portfolio of high-interest loans should do well. As rates fall, the value of that debt portfolio will rise, leading to capital gains. However, many banks and certain non-banking finance companies are in terrible shape with huge bad debts. There is a non-trivial chance of getting stuck with losses in a debt portfolio.

Under the circumstances, I would prefer to look at short-term debt, being prepared to roll over bank deposits with a 30-day to 90-day profile. Alternatively, I would enter liquid money-market funds, to earn some returns while hoping for better equity valuations. Debt funds dealing with instruments in that 30-90 day timeframe would also be attractive. Such short-term fixed deposits could be redeployed quickly and debt funds should log capital gains, if there are rate cuts.

The author is a technical and equity analyst