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Suresh Krishnamurthy

THE relentless compression in the yields of debt securities over the past year or so has significant long-term consequences for an investor. The expected long-term return on debt is now under 10 per cent, even for maturities of 10-20 years. In contrast, the rate of inflation expected in major areas such as education and housing does not appear to have come down. Successive Budgets have failed to break the back of inflationary expectations. This suggests that one needs to change strategy to be better able to achieve investment objectives.

Investors have three options. They can increase the amount of monthly savings so that, even if the returns are lower, their investment objectives are achieved. Or, they can consider raising the allocation to equities and take higher risks. The third option — one not likely to find favour — is to scale down one's investment objectives.

The events of the past couple of years have had the unintended consequence of pushing investors towards equity. Equity has delivered attractive returns over the long term. Since 1978-79, the BSE Sensex has gained around 17.8 per cent per annum. An actively managed portfolio would have gained significantly more and posted returns of even around 25 per cent. In contrast, returns on debt instruments may only have been around 15 per cent, at best.

However, there are risks too with equity. For instance, between December 1994 and now, returns from debt have outperformed the Sensex considerably. An actively managed portfolio may have done well over this period. Yet, it is a moot point if the returns would have compensated for the risk involved. Thus, investors may need to be adequately prepared for such setbacks if they plan to invest in equity. They also need to be patient to hold these investments for over 10 years.

Importantly, the expectations of returns from equity might themselves need to be scaled down. The expected returns from equity are partly a function of the expected returns from risk-free securities. The latter have declined to less than 8 per cent over the long-term from 12 per cent plus five years before.

The fall in the returns from risk-free securities will influence the expected returns from equity too. The prices of stocks will be bid up in course of time to reduce the returns from investment. There may be a time lag between the fall in expected returns from debt and a rise in equity prices. This could even take a few years but will happen eventually.

Along with reduced returns from equity and debt, investors may also need to contend with increased volatility. Notwithstanding the fall in inflation based on wholesale price index, its back does not appear to have been broken. Higher inflation may lower real appreciation in value. This may lead to considerable volatility in the prices of both equity and debt.

Investors need to factor this in too while planning to accumulate for the future. This requires greater clarity on investment objectives, separating long-term and short-term funds, and balanced asset allocation. In short, investors may need to work harder to earn better income from investments.

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