We have heard of black swan events. These are rare, almost improbable events that aren’t predictable. Yet, they explode on our faces from time to time. The coronavirus pandemic is certainly a black swan event – one that no one anticipated, much less prepared for.
Almost all countries are now affected by this virus, differing only by the extent of the spread, and that has caused shutdowns in the economies, to varying degrees. If this situation persists for some more time, it will doubtless affect businesses and the economy as a whole.
Hotels, theatres and malls are fully shutdown, and hence these businesses have no income. Various manufacturing outfits are not able to function due to restrictions on people as well as raw material movement and availability. Some shops selling groceries and essentials are open, with restrictions. ECommerce outfits are unable to function. The net result is that commercial activity has wound down significantly.
Financial impact of the lockdown
Businesses may be unable to pay employees, vendors, will be unable to service their loans etc. This can also mean job losses, if such a situation continues for long. There can be a domino effect across the economy as loan servicing will get hit and defaults may start rising.
If this were to happen, it can have an impact across the board in the fixed income space. Depending on the severity of the problem, it can affect debt papers of all hues. Rating downgrades will follow and the holders of debt papers may not receive the interest or even the principal. This can affect banks as well.
These events can happen if businesses are unable to operate for extended periods and there are no mitigants. Governments are certainly expected to intervene and ensure that this does not happen, as they do not want wholesale loss of jobs or the full capitulation of the financial system. Hence, it probably may not get as bad as mentioned earlier.
However, it is best to evaluate your options in a turbulent scenario. The situation that we have today calls for evaluating a move towards safety, capital protection and the comfort of regular payments, though that can mean some compromises. Some of the compromises may be lack of liquidity, long tenures, lack of regular income, low returns, tax inefficient nature of the instrument etc.
But some of the avenues we are going to discuss may appeal to investors due to the safety and low-risk nature of the instruments.
As a general rule, debt instruments that are issued by the government or their extended arms (like PSUs) will carry very low risk. In a situation like this, they are safe-haven instruments. Let us look at some of them.
Bharat bond fund of fund: This option has AAA-rated PSU bonds as the underlying investment, making it quite safe as an investment option. It tracks the Nifty Bharat Bond Index and is a passive fund with very low charges. There are three-year and ten-year options.
The ten-year option will certainly offer long-term capital gains benefit with indexation on principal.
It is quite attractive, as the post-tax returns are expected to be better than any other debt investment option. It is also liquid and can be exited anytime.
The negatives are that you should get into this option only if you have a seven-year horizon or more. This ten-year product may also be subject to much higher volatility on account of interest rates, in the short term, though it will even out over time. This option does not provide any regular income.
Government securities funds: These are MF schemes that have government securities as the underlying instruments. Due to this aspect, they are virtually risk-free.
These are actively managed funds and are typically held to maturity. Such schemes have a long tenure and hence are ideal to hold for a duration of five years or more. Liquidity is not a problem as one can cash out from the scheme any time.
The costs are higher in these funds as compared to the Bharat bond FOF. Even these funds will be subject to higher volatility in the short term but will even out over a period. Again, this is a tax efficient instrument, in that the LTCG with indexation benefits can be availed, due to which the post-tax returns are better than in most debt instruments.
Banking & PSU debt funds: These schemes are debt MFs with the underlying being banking or PSU debt papers. Thus, they are safe.
The advantage in this investment is that these are of shorter tenures of under three years and are suitable for those looking to park their money for a lower duration. The volatility on account of interest rate movement will be lower.
Liquidity is not a problem. These are actively managed funds with somewhat higher expenses charged to the schemes.
Other debt MFs: There are various categories of debt MFs such as corporate bond, short-term and medium to long term funds that also have high-quality papers as on date. These are good for now.
These are any day safer as compared to corporate FDs/NCDs/Bonds, as a debt MF holds multiple papers. Even if one defaults, it has limited impact as it is a small portion of the portfolio. The other attractions in this option are excellent liquidity, shorter tenures, tax efficiency (if held for three years or more), diversification of risk due to a basket of underlying securities and a professional fund manager being present.
If the situation in the economy worsens, one may have to shift to the other three avenues discussed earlier.
PSU bonds: PSU bonds of both tax-free and taxable variety are available in the secondary markets. They are safe. They also provide regular returns, mostly on a yearly basis.
Liquidity is poor and money will get locked up; any liquidation in between will have to be at a good discount. Hence, you should invest in these instruments only if you are clear about holding them till maturity. On a post-tax basis, they can offer 5.5 per cent or less as of now. They are still better than returns from FDs or even high-quality corporate debt papers today.
Bank FDs - This is an instrument that everyone is familiar with. Invested in a PSU bank, it is safe. Liquidity is good but returns are low. Regular returns can be made. Interest income is fully taxable.
Small savings schemes - Small saving schemes from post office such as term deposits, NSC and KVP are safe instruments. However, their post-tax returns are low, have somewhat longer tenures (except term deposits which have varying tenures), liquidity is poor and interest is fully taxable. NSC and KVP do not offer regular income. However, these will appeal to many due to the simple nature of products and safety.
RBI bonds: The RBI has come up with 7.75 per cent taxable bonds, which are very good in today’s situation. Interest is paid half-yearly, though a cumulative option is available. This has a seven-year tenure and hence is suitable for those who can keep the money invested for this period.
The choice of instrument must be based on various parameters such as safety, liquidity, tenure, regular returns and tax efficiency.
One should make the moves after evaluating the evolving situation. After all safety of one’s investment is what is of paramount importance, in a highly uncertain environment.(The writer is a SEBI Registered Investment Adviser & Founder of Ladder7 Financial Advisories)