I’d would like to begin my article by sharing some powerful money quotes
from W.G.Summer.
"Money is one of the oldest human inventions and one of the
most important, there is none that has been perfected so slowly. Money and
financial system are still work in progress. They are still evolving. And
anything that is still evolving has its share of problems".
The first line of defense for the public's continued support for
the FD is they are unwilling to come out of their comfort zone in terms of
investment. Furthermore, the public are neither aware of nor willing to accept
the other investment products that are both safe and profitable.
In this article, I will walk through over the debt fund which
could be used as alternative to FD. I have made deliberate attempt to keep the
article short and simple
Please skip the sections that follow if you are familiar with bonds and debt funds. To get to the main section, "Gilt Debt Mutual fund - An alternative to Fixed Deposit investing," keep scrolling down.
What is Bond?
Prior to understanding debt mutual fund, first we should know
about bonds. The Debt mutual fund is a basket comprising portfolio of various
bonds. No prior rudimentary knowledge about the bonds increases your risk of
picking the wrong debt MF. Hence here, Iam persuading the readers to understand
the basic fundamentals of the bond. The word "Bond"
sounds very familiar and may be easy to define.
Bond is an agreement between issuer and investor. The party,
which have fund shortage for a particular cause or initiative, issues a bond to
the open market. In turn, the investor
purchases the bond expecting good returns as obliged in the bond agreement.
Here, the issuer could be the government or the corporate. Hence, primarily the
bonds are of two types namely - Government bond and Corporate bond.
What is Government Bond
Government Bond are issued by state and central government. These bond fall under the category of government securities
(G-Sec). Government bond are mostly risk-free as they invest only in
government-oriented works and they don't default in paying out interest and
principal back to the investor. The returns are relatively low when compared to other bonds.
What is Corporate Bond?
On the other hand, private companies borrow money from the public
by issuing corporate bonds and debentures in order to expand their business and
meet their working capital. The bondholder are promised higher fixed rate of
interest. Their promised returns are relatively higher in comparison with the returns
of the government bonds. Corporate bond have
higher risk than government bond.
How Bond system works?
The bond issuer makes a promise to pay bondholders a fixed sum of
money at a future maturity date which is known as Face value. Every bond is issued with a fixed rate of interest per annum,
known as Coupon rate of bond.
Let's imagine this, Government runs a project called "Green initiative".
There is shortage of 5 Lakh required to complete the project. The govt plans to
raise fund through issuing bonds. Prior to unveiling new bond out to the
public, they monitor and analyse the various parameters in the market that are
highly influential. Finally, based upon the market movement and their case
study, the govt issues "Green Initiative Bond" offering 1000 units to
purchase, each unit costs at a face value of Rs. 500 @ interest rate of 10%.
Loan amount needed: Rs. 5,00,000
Face Value of the bond: Rs. 500
Total no of units offered: 5,00,000/500=1000 units
Interest rate/Coupon Rate: 10% [yields Rs. 50 annually per unit]
Maturity period: 5 years
Return type: Fixed returns
Issuer: Central/State
government
Green initiative Bond is now out to the public. Investors starts
to purchase the bond.
Why corporate bonds give higher return than government bonds? Here is the catch. Picture this, you are willing to loan Rs.1 lakh
and have option to choose between two borrowers. The first person is reliable
and trustworthy, agrees to pay you interest of 6% annually. The other one, who
has history of low credibility due to his loan default, willing to offer you
10% annually. Who would you choose, the reliable, consistent performer with low
interest rate or the one who has poor records on returning the capital and
interest but promises high interest higher returns. Eventually, in spite of the
lower returns, most of us would lend the amount to the credible person. This same strategy applies to corporate investment. Over
the years, few of the Corporate bonds failed to repay the loan and went
bankrupt.
This assertion that some corporate bonds have defaulted cannot be taken at face value. This doesn't make any sense that bonds which assures you high returns go
bankrupt or default on interest payouts.
Do profound market analysis before investing in bonds
Lower returns instrument doesn't require in depth analysis as they
fall into low risk. The high interest payouts eventually fall into high-risk
category. Before investing in a high-risk bond, it's advisable to research the
bond thoroughly, learning about its portfolio, interest risk, credit risk,
liquid risk and other prominent factors influencing your investment.
How do fluctuating interest rate affect bond prices?
Lets take the case of Green initiative bond.
Consider this, on the brighter side, after one year after
investing in this bond, there is slump in the market interest rate of the newer bonds, which means
the interest rate of a year old "Green Initiative bond" is relatively
higher compared to the new bonds out in the market. Green Initiative
Bond holder have the opportunity to sell their bond @ higher bond price
[Greater than Face value of Rs.500 per unit] as this bond is currently more
valuable in the market due to higher interest rate.
Conversely, two years after investing in this bond, there is surge
in the market interest rate, which means new bonds out in the market offer
relatively higher interest rates than the older "Green Initiative
Bond". In dire need to sell, unfortunately, the Green Initiative Bond
investors sell their bonds @ lower bond price [Lesser than face value of Rs.500
per unit]. So there is loss in their capital gains. There is inverse
relationship between bond price and interest rate. Bond price increases in case of lower market interest
rate and decreases when the interest rate is high in the market.
The above case study is an example of interest rate risk. Bonds are subjected to interest rase risk,
credit risk and liquid risk.
The brief overview of bonds may have aided you in understanding the fundamentals and how they function. Lets talk about the Debt MF.
Debt Mutual Fund
Debt, the word itself means loan. Debt MF is the basket of multiple bonds/securities such as
Treasury bills, Government Securities, Commercial papers, debenture and so on. The fund manager manages and allocates the
pool of investment money into fixed income securities. Debt MF invest in bonds
that have maturity period ranging from 1 day to 10 years. Interest rate risk is low for maturities less
than 3 years and more for maturities more than 5 years.
Should I invest in Bond or Bond/Debt funds?
For an investor, the crucial choice lies between investing in a
bond directly or in a bond fund through the mutual fund route. When you buy
individual bonds directly, you don’t have to pay fees to manage them. However, bond
funds offer benefits despite the operational cost. The biggest advantage of bond
funds is diversification.
Mutual funds can buy and sell bonds more efficiently than
individual investor. Professionally managed funds also generate high returns in
comparison to single bonds.
Debt funds are an excellent tax efficient alternative to other
deposit schemes such as Bank deposits or Post office deposits or other govt.
small saving schemes. Let's discuss their pros and cons
Pros of Debt fund:- No
Lock-in period, very liquid so one can withdraw money as and when one
requires.
- They
are significantly less volatile and less risky than Equity funds
- Few
debt funds offer better returns than other popular deposit schemes
- They
are an excellent tax efficient in case of long-term investments than many
fixed deposits due to indexation benefit.
- There
is less risk of defaulting as they invest in number of fixed income
securities.
Cons of Debt fund:
- Debt
funds carry interest rate risk and can add/reduce your capital based on
interest rate movement
- Debt
fund carry credit risk when some fund managers buy bonds of small
companies that offer higher interest returns but have higher chance of
default.
- Some
Debt funds have expense ratio of as high as 2.1% which is deducted from
your total return
Types of Debt fund
Some of the Debt funds are
· Overnight fund
· Liquid fund
· Ultra-Short Duration fund
· Money market fund
· Short Duration fund
· Corporate fund
· Gilt fund
Gilt Debt Mutual fund - An alternative to Fixed Deposit investment
Coming to the crux part of this article, Gilt Debt MF is termed as the alternate
investment vehicle in the place of FD. Gilt funds are debt funds that primarily
invest in government securities having holding period of more than 3 years. Roughly, they invest close to 80% of the
investment in the government securities. They give higher returns than other
debt funds that invest primarily in government securities. On the flip side,
this fund has higher chances of interest risk than other debt funds because of its longer holding period. As a general rule, the longer the holding time, the greater the
likelihood that funds may be exposed to interest rate risk. Hence, the longer maturity period of the Gilt
fund has higher chance of getting exposed to the risk of fluctuating interest
rate. On the other hand, other short term debt funds such as Overnight funds, Liquid funds, ultra-short funds, Short Funds have lower interest risk because of their investment in
securities having holding period starting from 1 day to 3 years.
Well, looking out on the brighter side of the Gilt fund
having maturity period more than 3 years, these funds protect your capital
gains from paying more taxes through the inflation indexation mechanism. Furthermore,
in spite of interest risk posing threat to the gilt fund, these funds have
lower likelihood of defaulting on capital and interest payouts to buyers.
Post Tax returns comparison of the FD and Gilt Debt fund
As stated above, the
MF are extremely tax-efficient in case of longer maturity period when compared
with FD.
Let me illustrate on
how the post-tax returns are calculated for the two investment instruments. Kavin invested 5 lakhs in a Debt MF with maturity period of 5
years, interest rate of 10% annually. According to SEBI, investments for longer
duration (> 3 years) are taxed at 20%. In Kavin's case, since the holding
period is more than 3 years, interest accrued would be taxed at 20%.
|
Deposit Amount
|
Rs. 5,00,000
|
|
Liquidity
|
Anytime
|
|
Premature Withdrawal
|
No charges
|
|
Partial withdrawal
|
Possible
|
|
Tax deducted at source
|
No TDS
|
|
Tax Rate
|
20% with Indexation
|
|
Interest
|
Rs. 3,05,255
|
|
Tax Amount
|
Rs. 61,051
|
|
Post Tax returns
|
Rs. 2,44,204
|
Raja invested in
Fixed Deposit having 5-year tenure offering interest of 10% annually. As per
the RBI standard, FD interest would be taxed @ 10%. In the budget of 2019,
government announced that tax is not applicable for accrued interest that is
less than Rs. 40,000 annually. In case of Raja, his interest accrued is
Rs.50,000 annually, which is more than the threshold limit, hence, his interest
accrued would be taxed @ 10%.
|
Deposit Amount
|
Rs. 5,00,000
|
|
Liquidity
|
Locked for tenure
|
|
Premature Withdrawal
|
2% on interest charged
|
|
Partial withdrawal
|
Not possible
|
|
Tax deducted at source
|
10% on interest
|
|
Tax Rate
|
30%
|
|
Interest
|
Rs. 3,05,255
|
|
Tax Amount
|
Rs. 91,577
|
|
Post Tax returns
|
Rs. 2,13,678
|
From the above FD table, the items highlighted in red clearly
indicates that these are the areas where FD takes the back seat. Post Tax
returns of FD, unfortunately, offers relatively less amount (Rs.2,13,678) in comparison
with Debt mutual fund Post Tax returns (Rs.2,44,204).
How could the Debt fund outplay the FD over reducing the tax on
the returns?
The answer is "Indexation" - powerful tool to save tax
for MF which are long-term in nature (more than 3 years). It helps in adjusting
the purchase price with the inflation level. Indexation rates are calculated
using Cost Inflation Index (CII). Following are the CII chart over the last 20
years.
To keep it simple, an item was priced at Rs.100 in 2001. Twenty
years later, the same item is priced at Rs.300. In the same manner, CII was 100 in 2001, but over time it increased to 300 points. It implies that money has lost
purchasing power when performance over the past 20 years is considered.
Generally, it is the rise in prices, cost of living and decrease in purchasing
power of money. The benefit of indexation would apply only if inflation is
positive. If the inflation rate turns negative, you might not get any help from
indexation. This is because indexation does not apply in a deflationary
situation.
Here is the formula for calculating indexation:
Indexation = Actual price paid for the investment * (CII for the
fund sale year/CII for the fund investment year)
Bottom Line
Certainly, FD is less risky and has less chances of bankruptcy. FD
is considered as Lazy-man's investment tool as the investors are unwilling to
take risk in the fluctuating market and they feel comfortable investing in less
risky instruments. Over the last 20
years, fixed returns from FD are between 6-8%, and unfortunately, this range of
return from the FD fails to beat the inflation and paying higher tax on returns. Assume this, the annual inflation is 6% and
returns accrued from the FD is 8% annually. It means the inflation has eaten
most of your returns and the left over (8%-6% = 2%) is your actual
returns.
The plight of inflation affects both FD and Debt MF. However, as
illustrated previously through the table chart, that Debt fund indexation
inflation mechanism acts as hedge against paying higher tax on the
returns.
Try incorporating “Laddering invest mechanism on FD”, in case you are not convinced yet on investing in Debt Funds. To
counter the fluctuation market, invest in FD wisely through the process of
Laddering mechanism.
Reference:
- Mutual Funds - R.K. Mohapatra
- 108 question and answers on Mutual Funds and SIP - Yadnya Investments.
