Giving debt its due

If your blood pressure moves in sync with the stock market or your mood swings according to the notional profits/losses your equity investments make, it might be time to buy yourself some peace of mind. Enter the world of debt.

Considered a low-risk, low-return investment avenue, debt investments were in much demand last year following the stock market meltdown. The basic principles of investments, in addition to diversification and capital appreciation, also stress on the importance of capital preservation.

While equity market investments help in building wealth, certain amount of funds, based on investor’s risk profile, has to be deployed into debt instruments.

So, even as the equity market recovers, one must not refrain from exploring debt options.

What follows is a primer on various fixed income instruments you can explore:

Bank fixed deposits: It is perhaps the most preferred savings instrument for an average Indian, which is explained by the fact that more than half of Indian financial savings every year go into these deposits. What makes them attractive is that they come in various tenors and there is no limit to the amount one can invest. Besides, the deposits up to Rs 1 lakh are insured.

As the network of bank branches increases by the day, it would be easy to open a fixed deposit at a branch close to your place. You can also get loans if you are an FD holder. However, the illiquid nature of these instruments puts it at some disadvantage. Currently, fixed deposits of major banks offer anywhere between 2 per cent and 8 per cent across all tenors.

Small saving instruments: With a fall in interest rates of fixed deposits, small saving instruments are back in vogue. These include National Savings Certificate, Public Provident Fund, Post Office Monthly Income Scheme and Kisan Vikas Patra. These instruments are backed by sovereign guarantee and offer returns of at least 8 per cent. In addition, PPF and NSC also provide tax relief.

However, the tax benefit under Section 80C is limited to Rs 1 lakh a year. Higher tenure of these funds may however expose you to interest rate risk. Here again, the illiquid nature of these instruments puts it at a relative disadvantage.

Corporate deposits: The deposits of companies offer a higher rate of interest than a normal bank fixed deposit, thanks to the disintermediation (that is, by bypassing the bank, which is an intermediary between a lender and a borrower). However, these come at a higher risk as they are unsecured and uninsured.

Consider them if you are willing to raise the stake a bit, but not before you take a look at the company’s fundamentals.

Well, if we were allowed to transgress a bit — why would one want to invest in debt of a company instead of equity? Simple. These instruments aren’t prone to volatility. Also, if the company goes bust, debt investors would have first right to the assets.

Non-convertible debentures: NCDs are not only secured in nature and give a high coupon rate but are also traded on the stock exchange. That addresses the liquidity constraint.

Another advantage is that in this case the market discovers the price of the issue and you needn’t pay any penalty for early exit as you can either cash out in the secondary market or use the put and call options the company provides for premature exits. However, the corporate debt market is still in its nascent stage and volumes traded in secondary market are still low.

Fixed maturity plans (FMPs): This is a fund, which has a fixed maturity and provides indicative yields similar to a fixed deposit. The yields of FMPs are higher than most of the debt instruments, making it an attractive option if you are looking for lock-in options. FMPs also have lower tax outgo, thanks to the dividend distribution tax. However, they are close-ended funds and therefore illiquid.

Monthly income payout, gilt funds and debt mutual funds are other investment options in the mutual funds category which provide liquidity. An optimal mix of investments have to be made in long-term and short-term income funds to reduce the risk of interest rate volatility and get steady income.

Gilt funds only invest in government securities reducing the default risk, but the yields may be lower than higher risk debt funds.

Debt floating funds are also a good investment option, especially during rising interest scenario as they eliminate interest-rate risk. However, there are very limited debt investments in India that have a floating rate.

Note that the debt funds’ net asset value fluctuates as the debt securities are adjusted to market prices.

Evaluating options: While the pre-tax returns for most of these products may come at higher single digits, the problem lies in what remains after adjusting for tax.

Given the present situation, wherein expectations of interest rate hikes are ripe, it may not be advisable for investors to opt for long-term debt options now.

Instead, consider short-term options and wait for interest rates to rise to take full benefit of the interest up-cycle.