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Debt means �No risk� & �Low return�? Wrong on both counts!

Published on Mon, Dec 17, 2007 at 11:38 | Source : Moneycontrol.com

Updated at Mon, Jan 28, 2008 at 12:31

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FD - The Basic Debt Product
The word 'debt' for most people conjures up the bank fixed deposit (FD). Carrying virtually no risk, it provides a fixed rate of return (~8.5% today) for the risk-averse retail investor. These are not without their disadvantages - for one, interest earned is subject to the highest tax bracket by clubbing it with investor's income. Moreover, FDs involve a lock-in, and any premature withdrawal entails a penalty. For most salaried individuals, it is easier to invest fixed amounts on a monthly basis rather than as a lump sum. FDs are typically not conducive for doing this conveniently; their cousin, the recurring deposit (RD) provides an even lower rate of interest and is hence not attractive.

NRIs have had the FCNR deposit, which is the foreign currency equivalent of the FD. They were popular in the past due to high interest rates offered (compared to what was available abroad), their full repatriation benefit, and the Rupee falling continuously against other currencies. However, interest rates on FCNR deposits today are very low (not over 5%), and the recent appreciation of the Rupee against major currencies has meant that real returns on FCNR deposits have been zero or even negative.

The Tax Free Option
The tax free debt option is mainly the PPF, which gives an 8% tax free return. However, the long lock-in period and the inconvenience associated with PPF maintenance has made it relatively unattractive, except possibly for a small portion of the retirement oriented savings.

In the last few years, asset management companies have launched products called fixed maturity plans (FMPs) and interval plans. These offer the better part of both worlds - they only have a lock-in of one or two years (depending on the plan opted for) and offer returns largely in line with FDs. But since they are taxed at only 10% if held for greater than a year, they become superior to FDs in almost all cases. Of course, you may not hear of them in the market too often, since the margin for distributors on these products is low. But this is precisely the reason the product is good for you as a customer! Application forms for these are available with any certified mutual fund distributor; or can be obtained from the asset management company directly.

Mutual Fund Debt Schemes
Most investors think of mutual funds only as equity investments. But in fact, mutual funds have more funds managed under debt schemes than even under equity schemes! A debt mutual fund is somewhat different from an FD - it offers the potential for slightly higher returns, but the risk is slightly higher. There is no risk in the sense of losing capital, but the returns could be lower in an adverse environment. Unlike an FD therefore, the amount returned is not guaranteed upfront - it depends on the performance of the bond markets in the intervening period.

Typically, a debt mutual fund would perform well in a falling interest rate environment. For instance, during the Feb 2001 to August 2003 period, interest rates were on a decline. Debt funds returned as high as 20% per year, as compared to the Sensex that returned -8.4% in the same period! In contrast, in the last year and a half, equity markets have returned in excess of 30%, while debt has returned hardly 5%, since the interest rates have been rising.

Performance Snapshot - Debt Mutual Funds

Mutual fund debt schemes are of various types - such as short / long duration, gilt / corporate debt, etc., but we will not go into details of these in this article. Suffice it to say that mutual fund debt schemes are good for investors with low to intermediate risk appetite. They are ideal for investors who desire somewhat higher returns than an FD, but are unwilling to put money in equities. For, unlike equity, a debt fund is unlikely to ever lose principal, even if the returns themselves are low.

Arbitrage Funds
This new breed of debt oriented investments has emerged in the last one year. Arbitrage funds are mutual funds that invest in equity, but hedge (cover) their positions entirely by a corresponding opposite position in the futures market. Thus, they have no net exposure to equities; and returns are similar to (and somewhat higher than) a normal debt fund. Even if the equity and debt markets perform badly, such a fund is unlikely to be affected.

Arbitrage funds have one other very significant benefit - from the tax perspective. There is beneficial treatment to equity investments from a tax perspective, compared to debt. Arbitrage funds are considered as equity funds for the purpose of taxation, though their returns and risk more closely resemble a debt fund. Investors can therefore avail of this benefit, paying no capital gains tax on investments held in arbitrage funds for a period greater than one year.

Investments for NRIs
As mentioned earlier, FCNR deposits have lost much of their sheen for NRIs. But the fixed maturity plans, debt mutual funds and arbitrage funds are all available for NRIs to invest in. By investing through their NRE accounts, they can fully repatriate the proceeds back to their country if needed later. Moreover, the NRE account is Rupee denominated, and so should benefit from the gradual exchange rate appreciation that is being seen.

Summary
Thus, debt is not a homogeneous set of assets. Based on individual risk appetite and desired returns, there is a good variety of schemes to choose from. They offer much better control over returns and risks compared to equity, and are thus ideally suited for the more conservative investors.

- Ramganesh Iyer

The author works with PARK Financial Advisors Pvt. Ltd., Mumbai. He may be contacted at info@parkfa.com.

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