| The recent stock markets gyrations would have left a lot of investors dazed. At this juncture, many would be looking at decent returns as well as safety of capital. |
| The answer lies in fixed income instruments, particularly debt schemes of mutual funds, since they provide higher post-tax returns than traditional debt instruments as well as a chance for capital appreciation. Let us look at some of these options and why they seem so attractive at present: |
| Simply put, interest rates have an inverse relationship with bond prices. If RBI cuts interest rates, this will lead to bond prices rallying, giving the investor both, income flows from the bond coupon, as well as capital gains. |
| This has already been happening over the last few months, where bond yields have fallen and investors have been getting quite decent returns in bond funds, especially longer duration funds. |
| This is because bonds of longer maturity periods are more sensitive to interest rate changes than shorter maturity bonds. This leads to higher capital gains due to greater increase in their market prices when bond yields fall. |
| For example, let us take two bonds of Rs 100 each, one of three-year duration and another of 10-year duration. The first bond yields 7.75 per cent and the latter returns 8 per cent. Now let us suppose bond yields fell by 50 basis points. |
| The price of both bonds would go up, to neutralise the effect of the interest rate fall, since they are currently giving higher interest than the market interest rate. While the price of the three-year bond should rise to Rs 101.33, the price of the 10-year bond would have risen to Rs 104.75. |
| Recent Debt Fund Returns: (Last six months returns per cent annualised, as on February, 19, 2008 |
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| Even if we are approaching a softer interest rate scenario, investors would do well to put their money into longer duration bond and gilt funds or actively managed bond funds, where the fund manager tries to generate superior bond returns by playing the yield curve. |
| Debt schemes of mutual funds also offer greater tax-efficiency. While investors have to pay income tax at the rate of 33.9 per cent on their interest income from conventional investments like post office schemes and bank fixed deposits, in case they are in the highest tax slab, mutual fund investors get to pay much less. |
| In case the investor takes the dividend option, an individual or an HUF has to face deduction of dividend distribution tax (DDT) from their fund's NAV at the rate of 14.16 per cent, while others like corporates have to bear a DDT of 22.66 per cent, both of which are much lower than the highest marginal tax rate and the corporate tax rate. The income in the hands of investors after this dividend distribution tax is completely tax-free. |
| For those investors who do not want the risk of changing bond yields and prices, the preferred investment avenue could be fixed maturity plans (FMP) of mutual funds. |
| They are available in various durations, from 3 months to 3 years. At this time of the year, 14 month fixed maturity plans are very popular, since they provide high returns to the investor with minimal taxes due to double indexation benefits. Here is how they work. |
| Suppose you invest Rs 1 lakh in a FMP of 14 months at an indicative yield of 9 per cent a year. Your total returns would be Rs 10,500. Now suppose the cost inflation index for this and the next financial year is 4 and 4.5 respectively. |
| This would enable you to get indexation benefits for gains equalling Rs 9,917. That is, only Rs 583 are deducted as tax. This too would get taxed at the rate of 20.6 per cent, since you would pay long-term capital gains tax on your income from investments of more than a year. |
| Thus we see that debt schemes of mutual funds offer a viable investment option, providing both regular income as well as chance of capital gains to investors. |
| The writer director, Touchstone Wealth Planners |
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