Give preference to debt funds

Rebalancing would imply booking some profits in equity. Or, one could consider balanced funds

The Budget provides a convenient set of projections for investors to review asset allocations. In a more generic way, asset allocations should be driven by a combination of age and ambition (or rather, of risk-tolerance). But every Budget offers some signposts about likely financial performance over the next year and that helps investors tweak. Age-related asset allocation, or life cycle investing as it's called, is based on a basic principle of reducing risk as you get older. A young person can allow equity investments to compound over time, as he or she can ignore short-term blips in the stock market. So, they should invest more heavily in equity. An elderly person should have a higher focus on debt instruments such as fixed deposits, since debt is lower risk and, thus, better fits the needs of older people.

Life cycle investing has some drawbacks. One is that it is impossible to predict life-spans. A real danger with debt is that inflation erodes the value of money and interest rates are often lower than inflation. So, a long-lived person might see debt investments reduce in value and, thus, have to compromise standards of living when it is no longer possible to earn more.

Another issue is that the stock market can go through long booms and busts. An elderly investor might find it difficult to shift allocations out of equity if he or she is unlucky enough to be retiring while a long bear market is in force. So, the rebalancing implied by life-cycle investing can be hard to carry out, without some element of timing the stock market.

Anyhow, let us assume that your purely financial assets are allocated in some ratio across equity and debt. That ratio will vary depending on your age, risk-tolerance, profession, holdings in other assets such as real estate and precious metals, etc.

The allocation ratio should also vary on the basis of what you think will happen to debt and equity in the next financial year. Alternative assets like gold and real estate are always hard to call. Gold should lose more ground, given the prevailing low interest rates worldwide. Real estate is beaten down and could take more of a beating if the government is serious about curbing the use of black money in land transactions.

What is likely to happen to debt and equity in 2015-16? There is a clear trend visible in terms of interest rates. The Reserve Bank of India (RBI) has cut policy rates twice this year and one of those cuts was post-Budget. It must be reasonably confident that inflation as measured by the Consumer Price Index will stay below the targeted 6 per cent.

The CPI trend is below 5.5 per cent year-on-year and the current repurchase rate is at 7.50 per cent, which means that the RBI has considerable room to push rates lower. Every repo cut will mean downwards pressure on commercial rates and on Treasury yields.

Assuming that rate cuts continue, the coming financial year will be excellent for debt funds and for anybody who has an existing debt portfolio. Every reduction in interest rates inflates the value of any prior debt issued at a higher interest rate. There should be capital gains for debt funds.

Also of course, lower interest rates encourage all sorts of commercial activity. Corporates invest more in creating capacity, individuals are encouraged to consume more. Financing projects also becomes easier for infrastructure developers. This is why lower interest rates are usually associated with higher corporate earnings.

Lower rates also translate into higher stock-valuations. The private equity (PE) ratio can be inverted to compare earnings with interest yields and conservative investors often make this comparison. PE ratios can rise as a result when rates fall. A sustained period of lower interest rates often sets off a stock market boom with higher earnings being valued at a higher PE.

Rate cuts should be good for the stock market as well. The caveat here is that stocks are already trading at high valuations. Earnings have not grown very fast in 2014-15 (first three quarters), and investors hope that earnings growth will accelerate in 2015-16. So this potential positive impact may be discounted to some extent.

In theory, given the potential for growth in fixed income segments, versus already high valuations in equity markets, it may be right to give debt funds some preference. Rebalancing would imply booking some profits in equity and switching to debt. Alternatively, the investor could consider balanced funds.