Saturday, December 4, 2010

All about Debt Investments

Equity, Real Estate, Gold and Silver, and Debt. These are the four broad fundamental asset classes in which we can invest.


When we invest in Debt, what are the options that we have? We can invest in bank fixed deposits, company fixed deposits and debt mutual funds.  Within debt mutual funds, there are general income funds or diversified debt funds which invest in a mix of debt instruments, gilt funds that invest in government securities of different maturities, liquid funds or money market funds that invest in overnight call money markets, short term debt funds that invest in medium-term debt of three months to one year duration, and fixed maturity plans. The returns on money market funds are not very high – they are designed as a quick redemption product and are attractive to corporate treasurers who otherwise have their money in current accounts that do not earn them any interest – hence we shall ignore money market funds as an option. Fixed maturity plans are funds that have a defined window, usually around a year, which buy and hold debt securities till maturity, and are like Fixed Deposits in nature with the tax advantages of a mutual fund.


How do we decide among the above options? Let's look at some of the parameters that will help us decide.


First, the macroeconomic situation. Are the interest rates in the economy likely to go up or down? You don't have to be an economist to figure this one out. All you have to do is follow what the pundits are saying, and what are the market expectations currently. For example, as on date, the expectation is that RBI will not increase interest rates further, or at least even if it does, not by too much more. The last year and a half has seen steady increase in rates as RBI was battling to fight inflation. With inflation pressures easing, RBI will go easy on its rate hikes. Will the rates come down in a big way?  That is unlikely in the near term. So we could say that the outlook is stable in the near future.


Second, the tax rules. Interest on Fixed Deposits (even cumulative deposits – you have to add accrued interest every year to your income) with banks or companies is  considered as income and taxed accordingly at your marginal rate of tax. So the tax rate could be anywhere up to 30 percent.  The principal, when you get it back, is free of tax since you get back the money you put in – hence there is no capital gain or loss. For mutual funds, the situation is a bit more complex. The rules are different for debt funds, and for equity funds. For this discussion, we shall ignore equity funds.


There are two kinds of incomes you get from a fund, dividends which are like interest, and capital gain or capital loss on redemption.  When you invest your money in a fund, you can choose the dividend option or the growth option. The fund keeps accruing interest on its portfolio of investments and your NAV keeps rising – what is different is the way it is distributed. The money that is distributed comes out of your corpus in every case, and hence it would make no difference what method of redemption you choose, except for the fact that the tax rules in every case are different.


When you choose to receive dividends, you are not subject to tax on the dividends you receive. However, there is a dividend distribution tax that is paid by the fund from your corpus, which is 12.5% for individuals in case of a debt fund that is not a money market fund. Hence, the tax that you pay is effectively 12.5%.  When you sell the units, you are subject to capital gains tax on the sale price minus purchase price, i.e., the capital gain or loss. If you have held the units for less than a year, you pay capital gains tax at your full marginal rate, i.e. as if it is ordinary income. If you have held the units for more than a year, you pay the tax at the rate of 10% of the gains. There is also an option of paying 20% on the capital gains post indexation adjustment, but we can ignore that, since 10% is likely to work out to a lower amount.


So if you are a person who pays tax at the highest marginal rate (i.e., with an income greater than Rs. ten lakhs per annum), your tax rates effectively are:

30% (I am ignoring education cess) on Fixed Deposits and on sale of units held for less than a year,

12.5% on dividends and

10% on capital gains on sale of units that are held for more than a year.


There are further complications as well.  If you choose the dividend re-investment option, the fund declares a dividend periodically, which period could be even daily, and reinvests the proceeds automatically in the fund. In effect, you end up with a growth option, with the tax incidence of a dividend option! So if you want to invest your money for less than a year, but do not want to pay tax at your full marginal rate, you have the option of paying 12.5%.


As an individual I would consider investing in any of the following: Bank Fixed Deposits, Corporate Fixed Deposits, Short term debt funds, Diversified Income Funds and Fixed Maturity Plans.

The interest rates on Bank Fixed Deposits currently range between 7 and 9 percent for deposits greater than a year, and the interest is subject to tax at your marginal rate, say, 30%. The yield net of tax is thus in the region of 5 to 6 percent. With Fixed Deposits you are locked in for the period you specified, and pay a penalty in case of premature redemption.  Your money is insured for upto Rs. One lakh in any one bank, and if you have invested in a large bank, it is very unlikely that the RBI would allow the bank to go bankrupt and renege on commitments to depositors.


The interest on Diversified Income Funds and Short Term Debt Funds, you can assume to be in the region of 6 to 8 percent; however, they come with a tax advantage. You pay tax at 12.5% on the dividend option, and 10% on the capital gains, if you hold the units for more than a year. The net-of-tax yield is in the region of 5.5 to 7%. There is no lock-in; however the interest rates are likely to vary depending on market conditions and the fund manager's performance. There is no insurance – however, like in any fund, your insurance is in the form of diversification within the fund – the fund invests in several instruments of several different companies.


Corporate Fixed Deposits offer 9 to 12% currently for greater than one year duration – the tax rates are the same as Bank Fixed Deposits, giving an effective yield of 6.5 to 8.5%, while the risks are higher. If the company goes belly-up, you lose your money.


Gilt Fund returns vary – you should invest in gilt funds only if you feel the interest rates are going to fall in the medium term; if you feel interest rates are going to rise, you should shift your money elsewhere. Given the hassles involved, I would suggest that individuals should stay away from investing in gilt funds. The tax rates on Gilt Funds are the same as for any other Debt Fund. To the extent a Diversified Income Fund holds gilts or long-duration paper, it is exposed to interest rate risk as well.


Fixed Maturity Plans are an option worth considering since they offer rates higher than one-year Fixed Deposits, in the region of 10%, while you pay tax at 10% (if held for more than a year) giving you an effective yield of about 9%.


I would avoid dividend reinvestment option. They are good for investments less than a year – as an individual, I would not go to that much trouble for short term money – the returns are not worth it since the amounts involved are low.


Interest rates keep changing and to that extent the rates indicated above will change. However, the relative attractiveness of the options are unlikely to vary by much, unless tax rules change.


PF and PPF are also good options to consider. In case of PF you get 9.5% (that's for this year – last year it was 8.5%) but you lock in your money, which is subject to withdrawals as per the rules. The interest earned (in case you hold on for a sufficiently long period and transfer to the new organization when you move on) is tax-free.


PPF yields 8% and the interest is tax-free. It is also subject to lock-in provisions.


Infrastructure Bonds offer you the option to invest upto Rs. 20,000 every year. You get an upfront tax exemption equivalent to your marginal rate of tax; your money is locked in for 5 years. The interest rates offered on the bonds currently available in the market are in the region of 7.5 to 8%. The interest you earn every year is taxable. Since you save tax on your upfront investment but pay tax on the interest earned every year, the net-of-tax yield works out to the same as the gross yield, i.e., 7.5 to 8%.


So, if you were to invest your money in debt, which of the above options would you choose?  There is no one answer; hopefully, what is given here should help you to decide. Not doing anything and keeping the money in your savings account offers 3.5%, while inflation, which we can assume is at 7 percent levels, steadily erodes your money!

3 comments: said...

even better if a guy is say 48 years of age, he opts for growth option. Lets the money stay there (you pay tax only when you withdraw) and touch it when you are 65. This ensures 17 years of compounding (i am not getting into asset allocation, i am assuming u want this money to be in debt). A bank FD FORCES you to pay tax in the year of accrual. If you wanna leave it untouched (sure it is optional) this is a good option, what say?

Dinesh Gopalan said...

!subramoney - absolutely - agree with you 100%

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