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Best ways to invest in debt
Volatile
interest rates and newer options mean you can no longer invest in fixed
income with your eyes closed. Here’s how to make the most of the changes in
the debt market.
Double-digit returns on fixed maturity plans
(FMPs). Tax-free bonds offering high interest rates. Banks luring customers
with fixed deposits they can break anytime without a penalty. And bond
funds poised to shoot up due to the imminent fall in interest rates.
Investors in fixed income have never had it so good. Or so it seems. Though
the debt market is brimming with choices, financial advisers warn against
random investments in debt instruments. The notion that you can invest in
fixed income options with your eyes closed is no longer true. Focusing only
on the interest rate offered could backfire if one doesn’t examine the tax
treatment of the returns, or the liquidity and flexibility offered by the
product. “Before investing, one should understand how the product works,
how liquid it is and if there is a penalty for premature withdrawal,” says
Rupesh Bhansali, head (distribution), GEPL Capital. More importantly, one
should examine how the investment fits into one’s overall financial plan.
In the past few months, taxfree bonds and FMPs have flooded the market.
Investors who stocked up on these long-term bonds and FMPs without giving
much thought to their cash flow needs would have had to exit at a discount
to the issue price.
Our cover story this week looks at smart fixed
income strategies that can help you optimise returns, ensure liquidity and
minimise tax without compromising on safety. maximise returns. For example,
you can build a ladder of debt instruments of varying maturities to ensure
money flow for future needs. Or you could use the indexation benefit to
reduce your tax to almost nil. This is a useful strategy for those in the
higher tax bracket. Use these strategies to make the most of your debt
portfolio.
We have also listed some of the most common debt
instruments, along with their features, how they score on various
parameters and which type of investors will find them useful. Find out
which of these instruments suit you best.
THE LADDERING ADVANTAGE
The perils of predicting the market is often associated with the stock
market, but predicting the interest rate movement in debt market is equally
tricky. The benchmark 10-year yield is currently hovering around 9%. Many
analysts believe this is unsustainable and is likely to decline in the
coming months. So, financial planners are advising clients to buy bonds at
the current rates if they don’t want to take interest rate risk and invest
in medium-term debt funds if they want to benefit from the likely fall in
interest rates.
A lazy investor can avoid these timing issues and
use laddering to meet goals. “Consider building a ladder by investing in a
mix of instruments, such as fixed deposits, FMPs, NCDs and tax-free bonds,
which offer maturities from one year to 20 years,” says Gajendra Kothari,
managing director and CEO, Etica Wealth Management. For example, an
investor would invest in fixed deposits maturing in 2017 and 2018. He also
chooses a fixed maturity plan that matures in 2019 and a non-convertible
debenture that matures in 2020. He may go for 10, 15 and 20 year tax-free
bonds if he has longterm goals. This way he ensures that his money is
deployed across maturities. Each time a deposit or bond matures, he can use
the money or reinvest it. The advantage here is that you have to worry
about reinvesting only a small part of your portfolio at any given point.
If the rates have fallen, you still don’t have to lose sleep as most of
your money is still locked in at higher rates. “Laddering helps in
optimising returns and reducing the reinvestment risk,” says Vishal Dhawan,
founder, Plan Ahead Wealth Advisors.
However, to make the ladder durable, an investor
should ensure that the instrument he is picking will mature exactly when he
needs the money. This calls for a careful selection of investment options.
For example, you can pick up a fixed deposit or a fixed maturity plan to
fund your foreign holiday next year. If you plan to buy a car in three
years, you can invest in a 3-year FMP.
Take a close look at the features of the product to
ensure that there are no nasty surprises. For example, some bonds come with
a call option. If interest rates fall dramatically, the issuer of the bond
can exercise the call option and pay the capital plus interest and take the
bond back. This exposes the investor to the risk of reinvesting the money
at lower interest rates. One should avoid including such bonds while
laddering investments. Also, if you do not need interim cash flows, go for
cumulative interest options of bonds or growth option of fixed maturity
plans, say advisors.
CHASING TAX-FREE RETURNS
Deep-pocketed investors made a beeline for tax-free bonds last year.
Some even
liquidated assets to invest in these bonds that will give tax-free returns
for 15-20 years. Financial advisers were also nudging their clients,
especially retired individuals in the higher tax bracket, to put money in
them because tax on earnings is a big drag for those who live on interest
and dividends. “Fixed deposits offer 6% post-tax returns for investors in
the 30.9% tax bracket,” says Kothari. However, the tax-free bond issues
have suddenly dried up, and investment experts rule out any new issues till
the budget makes the necessary provisions. Many experts believe that the
new government may not clear issues of long-term bonds because it can be
huge burden on the PSU finances in the future. Traders have already sensed
an opportunity, and have been selectively buying tax-free bonds listed in
the sec- ondary market. In the absence of fresh issues, these bonds can
offer attractive returns. In fact, these bonds would offer huge capital
appreciation to investors once interest rates start falling in the economy.
That is why financial advisers are asking individuals to try the secondary
market to stock up tax-free bonds (see table).
After the issues dried up in the primary market,
most bond prices went up by 2-3% in the secondary market. Prices are likely
to rise further in the absence of new issues in the near future. Even if
the new government allows PSUs to tap the market, they will hit the market
with new issues only towards the end of the year. This is because the new
government is expected to present the budget only in July and even if the
government allows new tax-free bond issues, the companies will take another
three to four months before finalising their issues.
However, many experts believe that it is not wise
to wait for the new issues as they are likely to offer lower rates in the
backdrop of a likely fall in rates in the money market. The coupon on
tax-free bonds is linked to the yield on government securities of
comparable maturities traded in the money market. “If inflation goes down
and the new government manages its finances well, we may see low interest
rates in the future,” says Dhawan. Since the interest rates on tax-free
bonds are linked to interest rates prevailing in the economy, the new
tax-free bonds may offer lower returns.
It is easy to pick bonds from the secondary market,
as a buyer only needs to compare the yield to maturity (YTM) of bonds.
Since most banks are offering around 8.5% on the
10-year fixed deposits, rates offered by these tax-free bonds are
attractive even for the non-taxpayers. The only glitch is the step-down
clause in bonds issued during 2012-13. These bonds offer lower rates to
buyers from the secondary market.
Many investment experts believe that investors need
not be unduly bothered about the rating of these bonds, as all these
companies are top-notch PSUs. Though most issues are top-rated, there are
few issues with lower rating (AA+ and AA). Though the risk is not
significantly higher, the lower-rated bonds offer slightly higher returns.
According to experts, investors should only pick up
bonds that had large issue size (minimum `500 crore), as they are likely to
be traded more frequently in the secondary market. This is because even
though one intends to hold these bonds till maturity, one should always
have an exit strategy in case of a financial emergency. Most of these bonds
are not traded frequently in the secondary market and sellers are often
forced to sell their holdings at discounts.
Investors should also be aware of the taxation of
these bonds. Any short-term capital gains that arise when one holds the
bond for less than a year, will be taxed at applicable tax rates.
Investments in these bonds don’t qualify for indexation benefit as they are
interest-bearing instruments. Investors will have to pay a 10% tax on
long-term capital gains.
HOW TO TAME TAXES
The biggest problem faced by conservative investors is the heavy tax
they have to pay on the interest from fixed deposits . The interest is
fully taxable, which renders many debt investment avenues unattractive. If
a person is in the highest tax bracket, the post tax yield of a 9% fixed
deposit is whittled down to 6.3%. That also explains why tax-free bonds
have become a rage among retirees and high net worth investors. However,
investors can reduce the tax on their debt investments in other ways as
well.
For example, investors can opt for the in- dexation
benefit to maximise their returns. Indexation takes into account the
inflation during the holding period and accordingly reduces the tax. It is
available on investments for more than a year. The indexation benefit is
calculated on the basis of the financial year in which the investment was
bought and sold. Smart investors use this by investing at the fag end of
the financial year and redeeming at the beginning of another financial
year. So, a 13-month FMP bought in March 2014 and maturing in April 2015
will qualify for double indexation benefit. This reduces the tax to almost
nil or give you a credit in the form of a capital loss that can be set off
against other gains.
The systematic withdrawal plans (SWPs) offered by
mutual funds can be extremely useful for investors who want regular income
from their debt funds. Investors can use this facility to withdraw money
every month, quarter or year. Let us take the example of a
person in the 30.9% tax bracket,
who wants regular income from his 10 lakh investment
(see table). The income from fixed deposits will be fully taxable at the
marginal rate. In case of the debt fund, the entire withdrawal will not be
taxable. This is because a part of the redeemed amount is the principal,
which will not be taxed. Assuming that the NAV was at `10 at the time of
investment, it would grow to 10.90 after a year. So the investor will need
to redeem only 8,257 units to get the required amount. The bulk of the
value (8,257 x `10 = `82,570) will be principal component. Assuming that
the inflation during the year was 8%, the indexed cost will also go up to
`10.80 after a year. That means the taxable long-term capital gain is only
10 paise per redeemed unit. At 20.6%, the tax liability will be only `170.
Though the capital gains component and tax liability will keep on
increasing over the years under SWP, it will always remain far below what
you would pay on a bank FD. The effective tax rate after 10 years, 20 years
and 30 years under SWP strategy will only be 1.81%, 3.47% and 4.98%,
respectively.
Investors can also use capital losses—both
short-term and long-term—they have incurred to bring down their tax
liability. You can carry forward them for next eight years and use them to
reduce the tax liability arising from capital gains in the coming years.
DON’T IGNORE YOUR ASSET MIX
Experts say many investors have tilted their portfolio towards debt in
a big way in the past one year. This was partially because of the
lacklustre returns from the stock market and higher interest rates offered
by debt products, mainly FMPs and tax-free bonds. But these investors can
get into a tricky situation if they have to exit their investments
prematurely in an emergency. This is because FMPs and tax-free bonds,
though listed on the stock exchange, are extremely illiquid and rarely
traded on exchanges. One is often forced to sell at a huge discount.
This also means an investor should review her
portfolio to see if it has tilted too much from the original allocation. Of
course, this is possible only if you have an asset allocation plan in the
first place. “An investment plan helps you to define strategic asset
allocation and tactical asset allocation to various asset classes, which
helps you avoiding going overboard on any asset classes, even in euphoric
times. Also planned investments take care of your liquidity needs and in
turn help portfolio rebalancing needs,” says Vishal Dhawan. Timely review
can help investors rebalance their portfolios in line with their investment
plans that are aimed at achieving their financial goals, he adds.
TACTICAL ASSET ALLOCATION
Of course, one can deviate from the original investment plan as a
tactical move. In fact, many financial advisers say they made some tactical
allocation to debt last year because it was a great time to invest in debt
instruments like tax-free bonds and fixed maturity plans. However, even
when they had increased their allocation to debt, they deviated only
marginally (around 10%) from the original plan. For example, from the
original allocation of 60% in equity and 40% in debt, it has become 50% in
both equity and debt. In short, you are allowed to take advantage of the
higher interest rate environment or buoyant stock market by increasing your
allocation marginally.
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