- July 14, 2018
- Posted by: admin
- Category: Uncategorized
A basic mantra of smart investing has been ‘Do Not Put All Eggs in One Basket’. This simply means diversification across diverse asset classes like equity, debt, gold etc.
Equity offers an excellent wealth creation opportunity over a longer period of time specially in economy like India. Another asset class, easily the most preferred investment option among Indian investors, is debt on which we will focus today.
When we talk about debt investing we are talking about investment option which is less volatile compared to equity and offers return stability. When asked about investing in debt the first option that comes to retail investor’s mind is Bank F.D. because of its so called assured return status. But there is a life beyond bank F.D. While exploring options to invest in debt market, we will try to understand option of investing in debt market through mutual funds, how does it work, its advantages as well as disadvantages, current market scenario and comparing the same against bank F.D.
But before we go ahead and discuss about how to go about retirement planning and things to consider, lets try to understand at first as to why do we need retirement planning.
Basic Understanding about Debt/Income Funds:
Mutual Funds offer opportunity to investors to take exposure to debt securities market through debt/income funds, which otherwise remain out of reach for retail investors. Just as equity funds are ideal for investors with long term investment horizon of 5 years and above, for short term investment objective with conservative investor profile debt/income funds are ideal options. Within debt fund category, there are various sub category of funds like Money Market Funds, Gilt Funds, Income Funds etc. These are differentiated based on underlying security in which investment is made. For example, Gilt Funds invest only in government securities while Income Funds invest in corporate bonds, debentures also along with government securities. These securities can be of different durations starting from few months to as long as 20+ years depending on the interest rate scenario & outlook in the economy.
Relationship between Interest Rate Scenario & Debt Funds:
Market Price of debt securities are inversely related with interest rate movement in the economy. If interest rates go up bond prices go down and vice-versa. Let us try to understand this with a simple example. Assuming that current interest rate in the economy is 9% and as an investor I am holding a bond paper which offers me coupon rate of 10%. Now if interest rate in the economy falls to 8% demand for a bond paper which I have invested in offering 10% coupon will go up and so as its price because I will charge a price premium as interest rate has come down from 9% to 8%. Reverse will be the case if the interest rate will rise in the market.
In recent past during 2008-09 financial crisis after collapse of Lehman Brothers and Sub Prime problems in the USA, RBI had aggressively cut Repo-rate from high of 9% in July 2008 to low of 4.75% in April 2009 before increasing the rate again on back of inflationary problems. During period of 2008-09 when RBI reduced interest rate aggressively from high of 9% in July 2008 to low of 4.75% in April 2009 income funds had generated impressive double-digit returns.
Debt/Income Funds scores over Bank F.D.: One clear advantage of Income Fund against Bank FD is in terms of taxation.
Tax: Only for Long Term Capital Gain Tax ^ Assuming Growth Option
In terms of taxation, while any income from Bank F.D. gets clubbed in assessee’s total income; any gains from Income funds will be treated as capital gains. If investment is held for less than 365 days then it will be treated as short term capital gain (STCG) and any investment held for more than 365 days will be treated as long term capital gain (LTCG). STCG will be taxed at investor’s marginal rate of tax LTCG will be taxed either @10% without indexation or @20% with indexation. So someone falling in the highest tax bracket of 30% income funds/debt funds clearly score over Bank F.D. This investor also gets indexation benefit while calculating gain from income funds if held for more than 365 days. Indexation simply means adjusting your cost of purchase as per government declared indexed figures to adjust against inflation.
• Tax rate considered without surcharge and cess.
^ For Bank FD tax rate is assumed at the highest tax slab.
# This rate has been taken only on assumption and for example. This is not to provide any indication about expected rate of return from income funds.
As can be seen from the above table even if Income Funds generate return equivalent to Bank F.D. investor stands to gain by investing in income funds by generating higher tax adjusted return. However, mutual funds have the added advantage & risk of price fluctuation. In favorable market conditions, one can expect higher returns due to its inverse relationship with interest rates.
Other Options withing debt fund category:
Income/Debt funds discussed above are mainly suitable for investors with medium term investment horizon of upto 2 to 3 years.
However, within debt category, mutual funds also offer investors many other options to match their investment horizon which can range from few days to few years. Investors can manage their cash/emergency funds more effectively by investing in Liquid/Money Market category of funds. These funds come with very low return volatility and with negligible risk of capital loss. These types of funds are ideally suitable for investors with surplus money for few days to few months of investment horizon. We all maintain certain funds to meet any emergency requirements. Investors can look to put that in Money Market/ Liquid funds with expected returns of around 7-8% with tax advantage over savings/current accounts.
Moving up the investment horizon, there are Ultra Short Term Debt and Short Term Debt products.
As explained above, the performance of income funds depends on direction of interest rates as there is an inverse relationship between bond prices and interest rate. To avoid interest rate risk investors can look at funds which do not take call on interest rates movement but generate return through interest accruals.
Current Market Scenario:
After 13 consecutive rate hikes by RBI from low of 4.75% in April 2009 to high of 8.5% in Oct 2011 RBI has cut Repo-rate for the first time in April 2012 by 50 bps to 8%. There is pressure on RBI to ease interest rates and take soft stance with monetary tools on back of faltering GDP growth and weak IIP numbers. Main reason behind RBI’s aggressive rate hike policy was above average inflation, which hovered around 10% mark for most of 2010-2011. RBI will surely look at the latest inflation numbers on back of monsoons before taking any decision on rate cut. Without predicting about the future course of RBI action, we do understand that in scenario of interest rates softening in economy, debt/income funds category does tend to perform well.
Succesful investment management is largely about identifying the right asset allocation and managing the same. For investors having capital with short to medium term horizon, the opportunity to invest in mutual funds is attractive, especially against the traditional debt avenues used by investors. The Indian economy’s long term growth story also remains intact and the current market levels continue to be attractive for long term investments. However, irrespective of the market conditions, investors should always look at their own investment horizon and asset allocation and plan accordingly. By looking at your overall portfolio, there may be scope for debt investments, and mutual funds presents an ideal opportunity for you to look at…