There is very little reason that equity markets can give any returns in the short term that are commensurate with the risks.

It is surely more peaceful to keep the money in fixed income and wait for better times and/or significantly lower levels of share prices.

When it comes to investing in fixed income instruments, we have a plethora of choices. Let us look at some of them.

Price risk

Fixed income investments such as fixed deposits, bonds etc, are generally bound to pay a pre-determined amount on maturity and to that extent, one is certain about what to expect.

Yes, there is a risk to the principal if we try and ask for our money before the due date. We may have some listed bonds that keep getting traded.

They will track prevailing interest rate trends. They offer an exit avenue and gain or loss would dep-end on the interest rates.

The mutual fund route has its advantages and disadvantages. Unlike a debenture or a fixed deposit, there is no pre-determined amount that you will get back.

The net asset value (NAV) changes every day. If interest rates move up, the NAV falls and vice versa. Generally, mutual funds have a pool of assets and a mixed credit risk profile. To this extent, mutual funds are superior.

Taxation

Mutual funds are perhaps the best suited for tax arbitrage. Fixed Maturity Plans (FMP) of mutual funds offer a high level of tax efficiency, if you plan to stay invested for more than one year.

A direct investment in a fixed deposit or a debenture means that the interest income received by you is fully taxable.

If you are within the taxable limit, a listed debenture is good as there is no deduction of tax at source. In a fixed deposit, there is deduction of tax at source.

Of course, we also have tax-free bonds that are issued by NHAI or NABARD, etc but they are good when we expect interest rates to keep falling continuously.

Mutual fund routes have minimal taxation and offer some advantage. But they offer a lower return, due to expenses being deducted from the returns.

These are best when you expect a fall in interest rates over a year. By staying put, one can get the coupon plus the capital appreciation when bond prices rise on an interest rate cut.

Default risk

The risk is lower in bank deposits and government company bonds. However, it so not because of inherent strengths but due to government compulsions to ensure that there is no default.

Direct investment carries the highest risk, so use high credit ratings as a hurdle before you shortlist your choices.

Mutual funds also have a low default risk due to their diversification and a generally attitude to go in for higher-rated paper.

Of course, this cannot be guaranteed, since a few instances of defaults have happened in the mutual funds.

In a case that I recall that the sponsor fully compensated the scheme for the default, but such instances are rare.

Liquidity

Bank deposits offer liquidity but corporate deposits do not. Mutual funds have open-ended schemes that can be liquidated in a day or two, except for FMPs that usually impose a load on early exit, if at all. Bonds that are listed on the exchange can be sold with some difficulty and price discovery is difficult.

When you are selling a listed-bond, you need to be prepared to lose one to two per cent on returns. The tax-free bonds, however, have fairly good liquidity and can be sold in times of need.

Sector risks

The biggest issuers of bonds are finance companies and banks that take your money and lend it onwards.

Here the credit risk is about average and most of the companies tend to enjoy a credit rating that is higher than what they deserve in the long run.

Here I would not put my money in unless there is a rating of at least double A (AA) and the duration is around three years. Of course, there are exceptions like time-tested HDFC or Sundaram Finance.

The other thing is that we will see many companies offering 'perpetual' bonds, i.e. they promise never to repay you. It would be stupid to put money in to any of these.

The secondary market for bonds in India is very thin and you will get stuck with a lemon that will keep passing from father to son or the more likely possibility is that the company will die a death.

I would stay miles away from these kinds of instruments, unless they offer me something like 20 per cent a year. Since they do not ever repay principal, it is only fair that they offer at least 50 per cent higher interest than others.

(The writer is an independent analyst and can be contacted at balakrishnanr@gmail.com)