Nervous about debt funds? Take a call, depending on your risk appetite

Remember there is an element of risk in almost every investment option. Take a call, depending on your risk appetite

Over the past few months, many new investors would have realised that they could lose money in debt funds, much like equities. With Infrastructure Leasing and Financial Services’ subsidiaries defaulting and more recently, Essel Group entities holding back repayments, it hasn’t been a smooth ride for both investors and fund managers.  

While most investment advisors are still rooting for debt funds, there is a caveat now. 

“Even if one company defaults in the portfolio, an investor can still make 7.5-8.00 post-tax returns in a short-term debt fund if he stays invested for over three years and the scheme doesn’t have significant exposure to one group through multiple entities,” says Malhar Majumder, partner, Positive Vibes Consulting and Advisory. 

Adds Suresh Sadagopan, founder, Ladder7 Financial Advisors: “If an investor is not going through an advisor who can analyse the portfolio of a scheme, he should stay away from debt funds.” From a debt investor’s perspective, there are many other options. However, except a pure fixed deposit (FD) with a bank, there aren’t too many risk-free options. Interest rates on FDs from large banks range from 6.8 per cent (for one year) to 7.25 per cent (five years or more). For an investor seeking FD-plus returns, there are some other options. 

Lowest risk options: There are post office deposits which offer 7 per cent for one year and 7.8 per cent for five years. There are also Government of India savings bonds that offer an interest rate of 7.75 per cent. Small finance banks are more aggressive, and a depositor can get up to 9 per cent interest. A retail investor can also invest in government securities (G-Secs) directly during the auction using National Stock Exchange’s NSE goBID platform and Bombay Stock Exchange’s BSE Direct.

Tax-efficient products: One of the options for those in the 30 per cent tax bracket is arbitrage funds. These funds invest in equity shares and the futures market but generate returns that are in line with short-term debt funds. The one-year category return of these funds is 5.58 per cent. But don’t go by the average returns. Some funds in the category also take direct exposure to equity pulling down the returns of the category. Most funds have offered returns between 6 per cent and 7 per cent.

As arbitrage funds invest in equity derivatives, they are taxed as equity funds. If an investor redeems within one year of investment, he pays 15 per cent short term capital gains tax. For those who exit after one year; they need to pay long term capital gains (LTCG) tax. For an investor, the realised gains from all his equity investment are tax-free up to Rs  1 lakh, and beyond this, he needs to pay tax at 10 per cent on the profit.

If a person earns 6 per cent returns and his gains are below Rs  100,000, the effective return is around 8.5 per cent, and if he earns 7 per cent return, the effective gain is 10 per cent. Investment advisors suggest that investors should opt for a pure arbitrage fund, one that does not take equity exposure.

The second option is buying tax-free bonds from the stock exchanges.  In 2014, a few government companies issued tax-free bonds with tenures of 10 years, 15 years and 20 years. The interest rate offered ranged between 8.26 per cent and 8.79 per cent. “Though the secondary market is not liquid, some tax-free bonds are still traded. These bonds not only suit those on the higher tax bracket, but also senior citizens as they are backed by the government. But the buyer should understand how to calculate the fair value of the bond at the time of purchase,” says Sadagopan. 

Long-term, low-cost: The Tier-II account of the National Pension Scheme (NPS) is meant for investments. Subscribers can choose to invest and withdraw from it any time they wish. The Tier-II account comes with three options to choose from – equity, government bonds and corporate debt plan. The two debt options have much better returns than mutual funds. The three-year return from G-Sec funds of different managers ranges between 7.81 per cent and 9.89 per cent. For the corporate debt plan, the three-year returns are between 7.41 per cent and 8.25 per cent.

While the Tier-II account is like a mutual fund debt plan, its extremely low cost and works within the framework that the government has mandated. It is suitable for an investor looking for long-term debt investment. The low costs over the long-term add to the returns of the investor. There’s only one drawback. The government is yet to clarify the taxation of the gains made in the Tier-II account.

High risk, high return strategy: For those willing to take extra risk for higher returns, company FDs and non-convertible debentures can be alternatives. The risk is the same in both – the company can shut shop and depositors being unsecured lenders, will get back nothing. To minimise this risk in both the instruments, an individual should opt for well-known brands that have a track record of paying back customers for at least over a decade. A well-known company FD with a track record can fetch investors around 7.5-8 per cent for a one-year tenure and 8-9 per cent for a five-year deposit. The current NCD issues are offering investors interest rates of 8.7-9.25 per cent for up to three years to 10.75 per cent for five years. When investing in these instruments, spread your investments in three-four companies to minimise the risk.

Lend at a high rate on peer-to-peer platforms: Becoming a lender on peer-to-peer (P2P) lending platform can be rewarding but also carries the highest risk. An investor can make returns of 12-20 per cent. But the chances of an investment going bad is also high. These platforms connect individual lenders to borrowers. They also do the credit evaluation of the borrower and present it to the lenders. As a lender, you can choose to give money at a lower interest rate (around 12 per cent) for someone who has the highest probability of paying you back or can provide funds to a “risky” borrower at higher rates (up to 24 per cent).