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!

Dust the cobwebs of the night

Wake up! Greet the morning light with a smile.

Wipe the cobwebs of sleep from your eyes.

Do not wallow any more in the night.

The world awaits your presence outside!

 

The birds greet the morning with joy unbound.

The earthworm peeps its head out of the ground.

The morning dew twinkles on blades of grass.

Wake up! Go meet the day, it will not last!

 

The river winds its sparkling way onward,

Carrying blessings from another land.

The trees are laden in the orchard;

The fruits, ready to pluck, on every branch!

 

The night has gone back to its lair,

Retreating against advancing sun.

It's time you woke up from slumber and stirred.

Arm yourself, step out, take on the world.

Talking about Gold and Silver - Part 2

I did receive a few reactions to my article on gold a couple of weeks back.

(http://www.dineshgopalan.com/2010/10/talking-about-gold-and-silver-part-1.html ).

 

 Some of the main objections:

 

1)      Gold has no use for it, in the same sense that other commodities do – people don't need it to perform any useful function.  Its value depends on what people are willing to pay for it.

2)      A return of 6 to 7 percent in dollar terms and 11 to 12 percent in rupee terms is not really high

 

There are other objections usually advanced as well. That Gold is a dead investment, it's just a piece of metal with no productive use, prices are already high and where will it go from here…  Strangely, no one talks of silver much – it doesn't seem to evoke so much interest as gold.

 

Which is why in the history of the world more people have died fighting for gold than for any other cause – except religion of course!

 

Talking of gold not being of much use – is that not a desirable thing for something that is used as a store of value and a medium of exchange? Of what intrinsic use is the rupee coin you have? Historically, people across cultures have experimented with various forms of currency and the attributes that are required are:

                The sovereign cannot just print more of it whenever he wants (this is critical – we'll touch upon this again)

                It should not be affected by the elements

                It should be rare – else more and more of it will just reduce the value of other peoples' holdings

                It should preferably not have other uses since you do not want your currency to be consumed – only used to buy things that can be consumed

 

Gold and Silver have been most used in currencies over the years. It has invariably happened that the value of the underlying metal increases over time while the currency does not hold its value – obviously the coins are then melted for their intrinsic worth!

 

Governments across the world are just printing money as they wish.  They need this power to print money since it is the means of wealth distribution. Printing more money implies that (a) the value of the money you hold drops, and (b) the money that is printed newly can be deployed anywhere in the economy by the government, i.e., those in power.  They have just used their power of patronage to dispense largesse at the expense of all of us, and we do not even realize it! That's why governments hate to peg their currencies to any external value index.

 

Read the stories of hyperinflation across the world – Germany and Austria after the war, Argentina, and more recently, Zimbabwe, to see what can happen – and it's not an extreme doomsday scenario.  Well, it is extreme, and it is doomsday, but the way governements across the world are behaving now, it is not very improbable.

 

A return of 11 to 12 percent over the long term is not small. It is certainly a little higher than inflation. There is a lot of variability in y-o-y return, but we are only considering long term returns here.  Both stocks as well as real estate offer similar or greater returns over the long term. 

 

Between the two, silver is more volatile than gold. Silver has many industrial uses and a lot of it is consumed. Newer uses are being found for it in nanotech and other cutting-edge advances. Silver prices tend to go down more when economic activity is down, and increase more than gold when economic activity picks up, in line with other commodities.

 

For the long term I am bullish on gold, and more bullish on silver. Gold and silver should form part of every investor's portfolio – not the whole part of it, not a majority part of it, but certainly a substantial part of it.

 

How do we go about investing in Gold and Silver?  We shall see that in the next part of this series.

 

Volatility - the new Reality (Investing strategies for today)

When you invest in a piece of real estate close to your locality, where you think you understand the demand-supply dynamics, you are taking a bet on the future – that your plot of land will appreciate. This is an individual call and the returns that you may or may not get has no relation to the overall market, or with the national and international economy, at least to a large extent.

 

 The same argument applies to individual stocks; however, there is an additional twist here. However individual the stocks may be they do get influenced by the broad market and tend to move in concert especially in times of extreme volatility, more so  in case of stocks which form part of the index.

 

There are several institutional players in the market, all of whom are investing in the same basket of stocks and are being compared against the same benchmarks. The performance of all equity fund managers in India is measured on how well they performed vis-à-vis the Sensex , in one way or other. Hence they all have a huge incentive to try to second-guess the Sensex and to mirror its movements. Not doing that would be too much of a risk only maverick fund managers would be willing to take, and that too not for long, since their performance measures would tend to catch up with them.

 

I believe that when everyone is evaluated against a particular benchmark their performance will ultimately tend to follow the benchmark very closely.   There is a herd mentality that results in all institutional players behaving in the same fashion, and they control more and more of the money. It thus becomes a self fulfilling prophecy sometimes, sometimes a race to the bottom where everyone is vying to sell; and sometimes a euphoria-induced spiral to the top. The computer-based trading models worsen this situation since they could trigger off a one-way slide in case the markets steeply drop. FII inflows based on a commonly accepted "country-weightage index" only amplify the trend. As do cross-border money flows which results in disproportionate sums of money coming in or going out to move local markets across the world.

 

I still subscribe to the Benjamin Graham and Warren Buffett school of fundamental analysis, at least for old-economy stocks  – in the long run I believe "fundamentally sound" stocks will give good returns. But the long run is made up of several short runs; and the short runs are becoming more and more volatile. The performance of your equity portfolio today has a lot to do a lot with macro economic factors several of which have no direct relation to the company or industry of the company in which you bought the stock.

 

If we accept the above line of argument to be true, then our investing strategies need to change accordingly. The old fashioned "buy-and-hold for the long term" still works. In case you have picked your stocks well, it is a very good option to put your shares in a locker (that's only a figure of speech in these demat days!) and wake up once every few years to check the price. However, given that industry, economy, and company life-cycles are getting shorter nowadays, you may like to do that a bit more often just to ensure that your company continues to remain fundamentally strong.

 

While keeping the above strategy as the base, we should evaluate whether we need to modify it in light of the current situation. The way markets swing up and down nowadays, it is good to keep a close eye on the Sensex and take a call on the broad direction. One can never be fully right in this, of course, but we could take a position that, say, at today's 20k odd, the Sensex has some potential of upside with high volatility and risk; while with the Q.E.2, European crisis, etc. there is a significant risk of a steep crash that could be triggered off by some bad news.  Let's say the most likely scenario is that it will keep yo-yoing wildly in a band. Given this, would we want to shift some of our existing equity investments into debt or gold etf's and enter later, even if to buy the same stocks? It also has to do with the current outlook on gold and debt, of course. Gold has had a very good run in the last couple of years, and the upswing is showing no signs of reversal. Also, if there is a stock market decline due to some macro-related bad news like the US economy or Europe, there is every possibility that gold will go up still further. If one is unsure of both equity and gold, debt is of course a safe parking slot.

 

That implies of course that you should be able to switch between investment classes  with minimal cost. Some mutual funds do offer switch facilities – examine the costs of these options. I do not think this kind of switching should be done often; but there are occasions when you may take the call to switch. If you are invested in mutual funds, it is at least good to know switching costs in advance, and other things being equal, invest in funds that offer you this option at a low cost.

 

When markets were ruled purely by retail investors not acting in concert, investing for the long term without trying to time the market made sense. But markets are increasingly getting institutionalized. Market players are increasingly acting in concert. Euphoria is getting increasingly euphoric (for want of a better word). Panic is getting increasingly contagious. In such a situation, it is good to keep a macro-eye out and take a call sometimes and act on it.

 

I  welcome your views and comments.

Ben Bernanke

Two of my earlier poems...

 

The High Priest

 

Dipping his stick in magic soap,

He keeps blowing into the air.

Carrying a message of hope

The bubbles emerge, in thin air.

 

Fascinated, spellbound, we stare,

Holding our breaths, hoping they will last,

As each bubble dances in the air

We watch, fragile hopes floating past.

 

We hope he has imbued them with spells

To carry them through the turbulence;

We hope they won't break, nor dispel;

We pray in fervent desperation.

 

Greenspan kept blowing his bubbles

Till they blew up one day in our face.

Bernanke has now been installed

As High Priest: to convey all our prayers.

(written on 12-January-2010)

 

 

Uncle Sam's fairy tale

 

Cinderella's coach was created

From a pumpkin, couple of mice;

A turn of the wand generated

The coach, and all that was nice!

 

Greenspan used his wand very well,

Flooding the world with money;

But he was in charge of the press

That's known as the U.S. treasury!

 

Bernanke has now taken up

What Greenspan had long back started.

He is busy conjuring up

Dollars where none ever existed!

 

At the stroke of 12 she had to run,

For the magic would lose its power.

All fairy tales are good and fun,

Till comes the inevitable hour!

 

(written on 31-December-2008)