Stable Gains

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Stable Gains
Himali Patel - 24 August 2017

Everyone wants their money to grow. Some are willing to take risks for it to grow faster, while some are conservative and want to take the least risky path to grow their wealth. “Fixed deposit investment is safer than mutual fund and stock market as these are not subject to market risk,” argues Mumbai-based, Priyanka Sabnis. At 27, Sabnis has been a firm believer in putting her money into PPF and other assured return schemes that are available for those who shun investment risk. These are also the preferred choice of investing for retirees who are obsessed with the guaranteed returns as well as the capital protection that such instruments offer.

Over the past decade, the falling interest rates and rising inflation has left many of these fixed-return seeking investors shattered because they are no more getting the kind of returns they were receiving in the past. Slow job growth, changing demographics and fiscal reforms are all factors that are the cause of returns from fixed income investments going down. There is a category of mutual funds which are most suitable for investors seeking stability of returns – debt funds. There are several variants within debt funds, with a role and suitability for each one of them.

Role in portfolio

“Fixed income is a key ingredient to one’s financial portfolio, just like salt is to one’s food. Lack of fixed income may make the portfolio vulnerable, as the stability quotient would be missing,” explains Lakshmi Iyer, chief investment officer (Debt) and head of products, Kotak Mutual Fund. Simply put, fixed income can refer to an investment strategy which is intended to produce relatively fixed or stable income or counter the volatility demonstrated by equity investments. There is also asset allocation, to spread your investment across equity and debt to match your risk profile, which dictates the allocation to fixed income that you need to have.

Moreover, fixed income securities have historically demonstrated a low correlation to equities, which means there is little relationship between how the two asset classes have performed over a given time. Therefore, owning fixed income securities along with equities adds a potential risk reducing effect to an investor’s portfolio. So, when equities are on a run, it would be a good idea to increase your allocation to debt investments to counter the risks posted by the volatility of returns from equities.

“Fixed income funds need to be a meaningful part of your investment portfolio. But, the exact percentage would depend on your ability to handle the volatility and risk,” suggests Amandeep Chopra, head – Fixed Income, UTI Mutual Fund. Before we get further, unlike bank FDs or even the PPF, which has a clearly defined interest rate that one earns from them, there is no such stated returns from investment in fixed income or debt funds. However, investments in these types of mutual funds have the potential to earn better than the prevailing interest rates and these investments are also tax efficient compared to bank deposits.

Different hues of debt funds

Just as equity investments can be categorised based on market capitalisation, sectors and investment styles; investments in debt funds too has its share of categorisation. “There are various options available to investors depending on maturity of the fund,” explains Avnish Jain, head – Fixed Income, Canara Robeco Mutual Fund. The performance and structure of debt funds is based on three risk parameters – interest rate risk, credit risk and liquidity risk. “Depending on which strategy one invests in, the degree of these risks would change,” adds Iyer. Based on the risk ladder, liquid funds have the least risk, while monthly income plans (MIP) have the highest, because of an equity investment component in them.

Debt funds could also be slotted based on the end use that one is looking at them for. For instance, debt funds could be used to balance a portfolio, generate retirement income, help in pursuing short-term goals or just act as a resting place for cash, before one can deploy it into other investment instruments. “Money which is required within a period of three years should be invested in fixed income,” advises Murthy Nagarajan, head - Fixed Income, Tata Asset Management. He goes on to add that emergency money should be in fixed income securities because of their high liquidity.

Given the choice of investments within debt funds, ask yourself what you are looking for from investing in the debt fund and for how long before you zero in on the type of fund. Look at the investment time frame, credit risk and the overall allocation to debt in your portfolio. This way, you will be able to invest in the most suitable fund that meets your needs before putting in your money. Likewise, certain type of investments can be made only through debt funds. For instance, if you are looking to invest in government securities (g-secs), you cannot do so as an individual, because of the high entry barrier, but you can do so by investing in gilt funds, which in turn invest in g-secs.

Tax efficiency

At 58, Mumbai-based Rajendra Pandit has a safety-first approach with his money and is a great believer in fixed deposits and PPF in retirement as he feels they are easy to structure as income in retirement. “I don’t look at mutual funds, because investments are not safe in them. I prefer the bank over debt funds,” stresses Pandit. Like many others like him, Pandit doesn’t view his investments beyond the stated returns. This phenomenon does not take into consideration post tax return on their bank savings and deposits, where the gains are taxed.

Interest from bank fixed deposits is treated as income and is added to your income and then taxed, thereby reducing your effective gains. Moreover, banks also deduct TDS on interest income from fixed deposits. In the case of debt mutual funds, only the change in the NAV of the fund is taxed. So, one pays short-term capital gains (STCG) tax at income tax slab rates only if units are held for less than three years. Thereafter, investors benefit from long-term capital gains (LTCG) tax at 20 per cent, and that too only on that component of the gain that exceeds inflation.

For instance, if you earn 9 per cent per annum over 3 years from debt funds and the inflation rate is 5 per cent, you pay tax only on the incremental returns of 4 per cent. This is called ‘indexation’ and is calculated using the cost inflation index (CII). So, even if debt funds and bank deposits provide the same returns, after a 3-year period, one can get higher post-tax returns from debt funds. “If you look at benefits, there is enough history to demonstrate that fixed income funds having beaten deposit rates the tax efficiency adds up the gains,” adds Chopra.

Today, debt funds are also exposed to volatility because of interest rate fluctuations, which takes away an element of stability that is identified with them. However, these do play an important role in the portfolio of individuals, who are fast finding them to be an alternative to traditional fixed return instruments like bank deposits and small savings. How debt funds score over others is with the layered risk reward map that these present, compared to no such differentiation between other forms of fixed return options.

“When the stock market surges, investors forget about risk; for optimum results from investments, one should never forget asset allocation, which is spreading investments across both equities and debt option,” emphasises Iyer. Take this advice seriously, for debt fund options have a wide choice and appropriate place in your investment portfolio. Invest in debt funds, which could also be used as a better alternative to money resting idly in the bank.


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