January 25, 2020
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The D-Street Band

Risk-free returns as a habit are going out of fashion, equities is where it's at

The D-Street Band
Chirodeep Choudhuri
The D-Street Band
outlookindia.com
-0001-11-30T00:00:00+0553
Put a reformer at the helm of affairs in an economic system that is widely protectionist, and he'll keep you on your toes. P. Chidambaram is a reformer to the core and it shows in Budget 2005. The compulsions of coalition politics may have broken his reformist stride a wee bit, but he's started moving the pieces with the grand design in mind: weaning away a nation of risk-averse small investors who have been spoon-fed investment baby food for way too long. Chidambaram wants this overgrown baby to crawl, fall, and learn to walk on its own feet in the big bad marketplace.

Look at the measures he has put in place in Budget 2005 as the walker that will help this investor find his or her feet—and not lean on tax breaks and risk-free returns to reach his financial goals. That master plan may still take a while to unfold, let's for now drill down to the finer points of its prologue—Budget 2005—and see what it holds for your investments. Basically, we'll see how you can invest the tax exemption on the extra Rs 1 lakh—over and above the Rs 1 lakh annual income that'll not be taxed at all.

Lower returns from debt
Fixed-income instruments are already under assault from declining interest rates and rising inflation. They have been dealt another body blow with the withdrawal of the Section 80L clause. This section allowed you an annual deduction of up to Rs 12,000 on interest earned from specified debt securities, namely bank and corporate deposits, select small savings schemes and infrastructure bonds. In other words, interest income from these instruments of up to Rs 12,000 a year was exempt from tax.

With Section 80L abolished, you will have to pay tax on all your interest income, at your slab rate. It can hurt. In the highest 30 per cent tax bracket (plus 10 per cent surcharge), a pre-tax return of 8 per cent—the best offered by an on-tap fixed-income instrument (NSC, post office monthly income scheme)—shrinks to 5.6 per cent post-tax. With inflation currently at 5 per cent, your real rate of return (net of inflation) will barely beat inflation without the Section 80L provision. And that's the best-case scenario.

Down the ranks, it gets bleaker, and illustrates just why you can't afford to ignore equities to make your portfolio grow. Take infrastructure bonds, which offer an interest rate of 6.25 per cent tops. So far, if you hadn't exhausted your Section 80L limit, you would have pocketed that stated return. But when you pay an over 30 per cent tax, as you will now if you are in the highest tax bracket, your post-tax return shrinks to 4.4 per cent, which doesn't even cover for inflation.

The removal of the Section 80L provision makes the four PO schemes that offered this deduction less attractive. These are NSC, MIS, time deposits and recurring deposits (see table: The Big Cut in Small Savings). Nothing gained or lost for Kisan Vikas Patra (KVP) and the Senior Citizens Saving Scheme, as they didn't qualify for the Section 80L deduction in the first place. The PPF, however, just got better. Along with the Employee's Provident Fund (EPF) it retains its privilege of being a tax-free instrument—for now. And under the new norms for claiming deductions on investments (Section 80C), the PPF enables greater tax savings in the upper two tax brackets than before.

Although small savings schemes are still the best option in the fixed-income space, their returns edge is getting eroded. The Rakesh Mohan Committee has recommended aligning their interest rates to the market with a mark-up of 0.50 percentage point. If the panel's recommendations are accepted, it will lead to a sharp fall in returns of small savings schemes. For example, under the Rakesh Mohan formula, the 7.5 per cent five-year post office deposit will fetch just 6.25 per cent today.

Policy changes clearly show that we are gradually moving towards a system where small savings schemes don't get preferential treatment. That means they will return a little more than your bank deposits, which is not good enough to create wealth to meet your long-term financial goals. Take advantage of small saving schemes while they are around, but start looking beyond them, at equities. Now.

The new rules of tax saving
From a system where how much you invested and where you invested was decided by the tax laws, we move to one where your personal portfolio preferences can shape these investments. The new rules allow for more choice and flexibility, they liberate you from low-yielding instruments, while giving you a greater tax benefit than before.

Section 88, your favoured saving provision, has been replaced with an investment-linked deduction under a new Section 80C. The list of eligible instruments is the same as that under Section 88. However, the sub-limits which capped your investments in some instruments, notably equities, are gone. For the first time, debt and equity (read ELSS) are being treated on par for the purpose of tax planning. You can invest the entire Rs 1 lakh in equity-linked savings schemes (ELSS), as opposed to Rs 10,000 earlier, to claim the Section 80C deduction. Likewise, in any of the other eligible instruments.

If you are inclined towards equities, as you should be in an environment where post-tax debt returns barely beat inflation, ELSS ought to play a bigger role in your tax planning. Since they marry the unmatched growth potential of equities with the best tax savings possible under the new rules, you should look to maximise your contribution to them. But that doesn't mean you should allocate your first Rs 1 lakh to them.

There's a hierarchy to follow under the overall Rs 1 lakh Section 80C limit. To start with, avail of the deduction allowed for tuition fee and home loan principal repayment. Then, maximise your EPF—instead of 12.5 per cent of your basic salary, contribute 20 per cent. A tax-free, risk-free return of 9.5 per cent a year is not only the best fixed-income investment going, it is also good by itself. If you still need more debt exposure to derisk your portfolio, invest in the eligible debt instruments like PPF and NSC. The remainder should be directed into ELSS.

What you want to do is to claim the 80C deduction while investing as less as possible and without committing to long lock-ins. The first two entries (education costs and home loan repayment) don't involve any outgo, and are incidental benefits, and so you should max them. Likewise the EPF, which is deducted from your salary. PPF slips in before ELSS because it doesn't have comparable alternatives, whereas ELSS does, in the form of conventional diversified equity funds. Even if you exhaust your Rs 1 lakh limit, you can always invest in diversified equity funds to get your desired equity exposure.

Market-friendly
In spite of the fact that the market is trading near its historic high, equities still look good. What the market wanted was continuity in reforms and policies without any nasty surprises. It got just that. Says Devesh Kumar, head of research, ICICI Securities: "It addresses the crucial issues facing India—infrastructure and rural development, and provides stimulus for economic growth."

It creates conditions for investment that makes sustaining annual economic growth of 6-8 per cent a realistic possibility. Once again, the focus area is infrastructure which tends to have a trickle-down effect on the economy. India Inc too has reason to be happy. With the effective corporate tax rate cut from 36.6 per cent to 33.6 per cent, companies will see their profits increase by about 5 per cent.But there could be some surprise as depreciation rates too have been reduced and that could offset the overall tax benefit.

But more than these small cost savings, what should excite companies—and therefore you, as an investor—is the continuing prospect of buoyant demand which will ensure that the expansion plans that firms are currently undertaking lead to higher revenues and profits for them. By reducing taxes, Chidambaram is putting more money in your hands. When you spend it to buy a firm's products, you increase its sales and profits, which should lead to the company's share price rising.

With profits projected to grow 20 per cent or more, the bullish undertone in the market is expected to continue (see graphic: Why the Market Will Stay Buoyant). Post-budget, several brokerages have scaled up their Sensex target for the next 12 months to 7500. Even at those levels, it is valued at just 13 times its earnings for 2005-06 which shows the rally in the market is backed by performance.

It is also backed by demand. FIIs are pumping in money. Pension funds could make an entry soon. Chances are, small investors might channelise a good chunk of their Section 80C investments into ELSS.

Higher transaction costs
A minor irritant for the equity investor is an increase in transaction costs from June 1. The securities transaction tax (STT), introduced last year, has been increased (see table: Equity Trades Get Costlier). For the small investor, who does delivery-based trades and that too not frequently, and who targets a fat profit margin, the increase is negligible. Illustratively, if you sell units worth Rs 10,000, besides an exit load, if applicable, you currently paid STT of Rs 15. Now, you will pay Rs 20.

The one constituency of investors who have reason to feel hard done by is day traders. They speculate on profit margins of as thin as 0.04-0.10 per cent. With an STT of 0.02 per cent, their margin of comfort reduces, but not by an amount that puts them out of business. Says Andrew Holland, executive vice-president, DSP Merrill Lynch: "FIIs pay a transaction tax in most markets. Even after this increase, the rates are not high."

New investment options
Budget 2005 also offers a sneak preview of new options that are likely to become part of your platter in the foreseeable future. Chidambaram pressed for advances in two specific areas—launch of gold funds and revival of the secondary market for corporate debt paper.

Gold exchange-traded funds (ETFs) will make it easier for you to invest in gold. Says C.J. George, managing director, Geojit Financial Services: "Conservative investors like to allocate some portion of their portfolio to gold. Gold ETFs are a progressive idea, as they accommodate investors with small outlays."

The one segment in desperate need of progressive thinking is the corporate debt segment on stock exchanges. On most days, not a single deal is struck. Since institutional players are networked, they are able to meet their investment needs. But the absence of a market means this investment option bypasses the small investor. Chidambaram wants to kick-start trading in corporate bonds and also subsequently offer securitised debt and mortgage-backed securities on the same trading platform. Says A.K. Sridhar, chief investment officer, UTI Mutual Fund: "Among the many positives for the capital market, this commitment to develop the corporate debt market is the biggest." If it pans out as planned, expect more options in the corporate debt space.

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