Compare the post tax returns and tenure of debt instruments before investing.
Last week, the first indications of a rising interest rate regime emerged. For one, Union Bank of India announced an interest rate of 7.25 per cent on fixed deposits for 550 days. Also, L&T Finance launched a 8.4-8.5 per cent coupon rate on non-convertible debentures (NCD) to raise Rs 250 crore, with the option of scaling it up by an additional Rs 250 crore on oversubscription. This was the second NCD issue by L&T Finance, following the success of its earlier issue which offered coupon rates of 9.51 and 10.24 per cent, depending on a 5-or 10-year tenure, respectively.
L&T Finance’s recent issue gives an indication that there might be no appetite for longer tenure NCDs. And, hence, the tenure is of a shorter duration of three years this time.
Interest rates had fallen in the past several months but there are indications that they might be on their way up. Hence, it is important to decide on your debt strategy for the next one to three years.
OPTIONS
Before we look at what your debt strategy should be, let's see the options.
Taxable interest income options: Fixed deposits; post office Investments such as POMIS, KVP, NSC, recurring deposits and time deposits; GOI/RBI 8 per cent taxable bonds; senior citizens scheme (for people above 60 only); NCDs
Tax-free debt options: PPF, traditional life insurance policies and EPF (Employees Provident Fund)/VPF (Voluntary Provident Fund) Tax-advantaged debt options: Debt mutual funds (fixed maturity plans, bond funds, income funds, gilt funs and others. Let's take a couple of examples of fixed deposits and post office MIS.
Even if you take an inflation of 5 per cent, the return, post tax and inflation, will be around 0.94 per cent only
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Even if you take an inflation of 5 per cent, the return, post tax and inflation will be around 0.28 per cent only.
On the surface, the returns look decent, but real returns, post inflation and tax, can lead to serious erosion over time.
The focus should be on maximising real returns, post-inflation and tax. Hence, if you are in the highest or higher tax brackets, you must opt for debt investments that are either tax-free or tax advantaged, as given above. However, if you are in the zero or lower tax brackets, then having a fixed deposit offering a pre-tax return of 8 per cent will also mean a post-tax return of 8 per cent. This means you could, in this case, actually prefer a fixed deposit or a 9 per cent, Senior Citizen Savings Scheme (for senior citizens).
| Fixed Deposit Interest (%) | |
| Return | 9 |
| Tax | 34 (Highest) |
| Post-Tax Return | 5.94 |
| Inflation | 8.00 |
| Real Return (post tax & inflation) | -2.06 |
| Post Office MIS interest (%) | |
| Return | 8 (Excl Bonus) |
| Tax | 34 (Highest) |
| Post-Tax Return | 5.28 |
| Inflation | 8.00 |
| Real Return (post tax & inflation) | -2.72 |
RETURN AND RISK
The only tax-free investments as given above are PPF, EPF/VPF and traditional life insurance policies (endowment, money back, whole life and so on). EPF/VPF and PPF is the order in which tax-free investments should be preferred, as the returns are 8.5 per cent and 8 per cent a year. Traditional life insurance policies give a low return of anywhere between 4-5 per cent a year and, hence, can be avoided.
Tax-advantaged debt investments are essentially debt mutual funds and are investments where there is no income tax but either capital gains tax or dividend distribution tax (DDT). Since the long-term capital gains tax and DDT are much lower than the highest income tax rate, there is a direct tax arbitrage of around 20 per cent for someone in the highest tax bracket.
Again, if you are in the zero or lower tax bracket, then investments with a tax advantage generally do not matter, as even a taxable investment will offer a high post-tax return.
Every debt investment is exposed to the following risks:
Credit Risk: Risk of default by the borrower. A high credit risk means a borrower may not be able to pay back an investment at all
Interest Rate Risk: Interest rate on investments could go down, yielding a lower return. PPF returns were 12 per cent in early 2000, and since then are 8 per cent for the past several years
Liquidity Risk: Ability to exit the investment quickly at no or minimal cost/penalty.
SO, WHICH INVESTMENTS?
This will be based on your tax slab, liquidity needs, return requirements and risk profile but for most people, EPF/VPF and PPF are important investments. You should also have high-interest fixed deposits, as these can be utilised from a contingency planning perspective.
If you are in the highest tax slab, besides EPF/ VPF,PPF and high-interest fixed deposits, you should look out for debt mutual funds, namely fixed maturity plans (FMPs).
FMPs are essentially close-ended income schemes with a fixed maturity date. This could range from 15 days to two years or more. For instance, in a FMP, when the period comes to an end, the scheme matures, and your money is paid back to you. FMPs invest in fixed income instruments i.e. bonds, government securities, money market instruments, etc. The tenure of these instruments depends on the tenure of the scheme.
FMPs are a good investment, as they effectively eliminate interest rate risk. They make sense for someone in the highest tax bracket, but you should double-check its portfolio to make sure it has good-quality debt in it. The post-tax return can be two to three per cent higher than the one from a fixed deposit.
The writer is director, My Financial Advisor