5 points to consider before investing in a debt plan
Traditional and risk reluctant investors who typically go for deposits, bonds and debt mutual funds had a great year in 2011. Sure, the high level of inflation might have taken the shine out of some of the returns. Still, they are clearly enjoying double-digit returns from humble fixed income instruments - considered possible only in the stock market a while ago - and want to lock in their investments at attractive returns.
However, it is easier said than done. One has to think about factors like liquidity, safety and taxes before taking a decision.
Here are a few points you should keep in mind while investing in 2012:
1) Look at Debt plan rating/quality
At a point when instruments issued by corporate entities are offering yields in excess of 12%, investors may get tempted to chase all of them. But one should never forget that extra returns come on the back of extra risks. This is true especially when the Indian economy is slowing down and the global economy is exposed to the risk of slipping into a recession. "In recessionary times, working capital cycle of many companies expands and cash flows go down.
The Companies in such cases may find it difficult to repay their deposit holders or bond holders. Instruments with low rating connote higher risk. This is the time to be very careful with your money and not chase returns. More than return on capital, it is the return of capital that matters. Remain invested in AAA-rated instruments and in case of AA-rated instruments, be really selective.
In exchange listed instruments, high credit rating also brings the benefit of higher liquidity against the instruments with low credit rating. Highly-liquid instruments allow you to exit before maturity closer to fair value than the low-rated counterparts. If you are buying a paper rated less than 'AAA' with a view to sell it as interest rates correct, you may not realise full profits when yields come down, as selling at fair market price may not be possible due to lack of liquidity. Be it receiving coupon or playing the interest rate movement, investment in a bond with AAA rating helps.
2) Focus on post-tax returns
Many get carried away with 10% interest on bank fixed deposit or 12% offered on a corporate bond. But interest is clubbed to the income of the investor and taxed at the marginal rate. It hits hard if you are in the high-income tax bracket with tax outgo at 30.9%. In that case it makes sense to look at post-tax returns for a realistic picture. Fixed maturity plans offer better returns in case you have opted for the growth option for schemes with over one-year tenure, as long-term capital gains are taxed at 10.3% without indexation, or 20.6% with indexation whichever is lower.
But given the prevailing uncertainty on the Direct Tax Code, there are many advisors who advocate going by tax-free bonds to play safe. No wonder, the recent issue of NHAI tax-free bonds, offering 8.3% for 15 years tenure, was lapped up by investors. It is better to invest in such bonds to ensure healthy post-tax returns with minimum credit risk.
3) Think long
As interest rates are nearing the peak, it makes sense to lock in these rates for a long term if you are a traditional fixed deposit investor. Look at three- and five-year fixed deposits, if you are sure that your short-term needs are taken care of. And if you are not sure, instead of making one fixed deposit of say 5 lakh, opt for five fixed deposits of 1 lakh each. This will ensure that you can break the necessary amount of say 2 lakh before maturity and rest of it will enjoy the high interest rate for the remaining term.
"You can also look at five-year tax saving bank fixed deposits too, which will offer you the much needed tax break under Section 80 C and also lock in your money at interest rates more than 9%," says Jayant Pai, vice president, Parag Parikh Financial Advisory Services.
If you are willing to take risk, you can also look at investing in long-term income funds and gilt funds. These funds will offer you the dual benefit of locking in high-coupon and a possibility of earning capital appreciation over the next one year as interest rates move down.
4) Consider laddering
"Buying instruments of varying maturities will assure you of regular cash flows and won't expose you to either long end or short end of the interest rate curve. In the current situation, consider investing your money in a judicious mix of say 370-day FMP, 3-year FMP and five-year fixed deposits. This ensures that some of your money is invested in long-term instruments and the current high interest rates are well captured. Contrary to general expectation, if the rates move up marginally, your money maturing in the near-term can be invested at higher interest rates. The most important factor is that you keep getting your money at regular intervals as maturity proceeds to take care of your income needs. This works for those who may have to make some milestone payments, say towards their children's education.
5) Track macro economic factors
Fixed income investments are influenced the most by changes in macro economic factors. Though the asset class has turned attractive after a pause in rate hikes by RBI, there are some inherent risks one cannot ignore. One should also keep track of the global economy. Any further quantitative easing by the US can push up commodity prices, including prices of crude oil. This in turn will stoke inflation in India and make interest rates climb, spoiling the party. A better informed investor can take better investment decision.
A Checklist for Fixed Income Investors
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