Debt investors need to tread carefully in the fixed income market as the balance sheets of the two biggest issuers - the government and corporate sector - are not in the pink of health
One of the fastest-growing economies in the world may be staring at a recession for the first time in the last four decades. In fact, experts are even talking about a Great Depression ahead for India. These telltale signs are enough to cause panic among debt investors, already hit by the IL&FS default debacle. Interest rates, too, are on a decline, and are pulling down yields or returns. Real rates are already in the negative zone because of higher inflation and lower interest rates. The Reserve Bank of India (RBI) is also stressing on growth by reducing interest rates to support demand. "This situation of negative real interest rates is going to stay for some time," says Rajesh Cheruvu, Chief Investment Officer of Validus Wealth, a wealth advisory firm.
There is likely to be one more rate cut of 25 basis points (1 basis point is one hundredth of a percentage point) in the near future. The balance sheets of the two big issuers of debt - the government and the corporate sector - are also not in the pink of health, which raises concerns on credit risk.
The priority of investors today is to protect their capital investments. So, where should one invest his or her hard-earned money in these times? A number of options are available under fixed income schemes - from fixed deposits, company deposits and debentures to public provident fund (PPF) and debt schemes of mutual funds. The returns range from 5 per cent to 10-12 per cent per annum. Though there are decent returns, liquidity and tax benefits, nothing is guaranteed if one goes beyond the government paper. So, investors need to tread carefully.
The Fixed Option
Fixed deposits have, traditionally, been most popular among savers. Over the years, non-banking finance companies (NBFCs) and the corporate sector, especially manufacturing companies, have also emerged as issuers of fixed deposits. Banks offer the highest safety with moderate returns, while NBFCs and companies offer relatively higher returns with moderate safety. Well-known banks such as SBI, HDFC Bank and ICICI Bank offer fixed deposits at 4.30 to 5.0 per cent per annum. The rate for a five-year deposit is around 5.35 per cent per annum. If one wants slightly higher returns, the best bet is new, full-scale banks such as IDFC First Bank and Bandhan Bank. These two banks offer anywhere between 5.75 and 6.50 per cent for a year, and up to 6.75 per cent for five years. The reason for higher interest rate is the low proportion of low-cost funds in the portfolio. In addition, these banks follow a differentiated banking model of lending to MSMEs and self employed, where yields are higher. The new set of small finance banks (SFBs) also fits into this category since they have a large portfolio of micro loans. These SFBs offer a much higher rate of 7 per cent for a year and 8.25 per cent for five years. Bank deposits, including SFBs, offer a safety of deposit of up to Rs 5 lakh per depositor. Currently, every bank deposit is insured with the Deposit Insurance and Credit Guarantee Corporation (DICGC) up to a maximum of Rs 5 lakh in case the bank goes into liquidation. It is therefore advisable to go for a deposit of a maximum of Rs 5 lakh with new banks just to be on the safer side.
"One can actually choose multiple banks to protect deposits if they have a higher amount to invest," says a banker. For example, an amount of Rs 20 lakh can be deposited in four different banks (Rs 5 lakh each).
There are also tax benefits in bank fixed deposits. Interest up to Rs 10,000 is exempt from income tax. However, liquidity is an issue with fixed deposits, since banks charge for premature withdrawals. For those who dont need liquidity, there is the option of a five-year fixed deposit, which offers a slightly higher rate, though there is a five-year lock in. The amount up to Rs 1.5 lakh is available for deduction under Section 80C of the Income Tax Act.
In terms of returns, deposits in NBFCs and the corporate sector offer an interest rate of 200 basis points higher than bank deposits, but the risk factor is that these are completely unsecured. Currently, companies are offering high interest rates since they urgently need funds due to Covid disruptions.
Banks have limitations in offering higher rates since they are flush with funds. In addition, deposit rates are linked to lending rates. Fixed deposits of HDFC Ltd, Bajaj Finance, Tata, Mahindra and Shirram Group are quite popular in the market. It is advisable to go for reputed names and the highest credit rating of triple A.
One should, however, be careful in taking a decision solely on the basis of credit rating. In the past, even highest-rated Jet Airways, IL&FS and Dewan Housing have collapsed or defaulted in loan obligations, leaving depositors high and dry. While bank deposits are at least secured up to Rs 5 lakh, NBFCs or company depositors have to stand in queue with unsecured creditors for claiming their dues in the event of a liquidation.
Shopping For Higher Returns
For investors with a little more risk appetite in fixed income securities, non-convertible debentures (NCDs) issued by the corporate sector is a good bet. NCDs are unsecured instruments used by companies to raise funds from retail investors and institutional investors. The tenure ranges from a minimum of two years to as high as 15 years. Like in the case of company fixed deposits, the credit rating of the issuer is important - it should be highest rated or triple A.
The returns in NCDs at 8-12 per are higher than fixed deposits. In some cases, yields are 8-12 per cent. There is also more liquidity since NCDs are listed on stock exchanges. The listing window also offers the advantage of capital appreciation at the time of the exit. "NCDs can provide good capital appreciation if interest rates go down as prices of existing NCDs would command a premium," according to a wealth advisor.
In terms of taxability, the tax is paid on the interest earned at the time of filing returns since there is no TDS deduction. In addition, the sale of NCDs at bourses before maturity attracts short term or capital gains tax.
Advisers suggest investing in NCDs can be a good diversification strategy to park a part of the funds. But there is a caveat. "Your diligence level of companies in terms of ratings, cash flows, leveraging, sectoral update has to be very high. There are also risks associated with parking your savings in a single issuer," says Anand Varadarajan, Business Head at Tata Mutual Fund.
Then there are lessons from the past as well. Post 2008, large companies with billion-dollar acquisitions in the commodity space saw their fortunes dwindling. Similarly, the boom in infrastructure, power, roads and real estate saw a not-so happy ending post 2014. More recently, Covid hit the best names in hospitality, tourism and transportation. "You are on your own if you are just looking at the credit rating. In the past, best-rated companies have defaulted," says a debt manager.
There are also liquidity issues. "The higher the outstanding debt amount, the higher will be the liquidity in the paper in stock exchanges," says Cheruvu of Validus Wealth.
The PPF Option
Public Provident Fund (PPF) offers the best option for long-term invests. Currently, PPF offers an interest of 7.1 per cent per annum for a 15-year lock-in period. The interest rate, which is notified every quarter by the government, is much higher than bank fixed deposits. The entry-level amount is just Rs 500 and a maximum amount of Rs 1.5 lakh is available for investment every year.
The only issue here is liquidity, though there are windows available. For someone in need of funds, the loan facility is available from the third year onwards. Similarly, there is also a partial withdrawal facility available after the competition of six years.
There are tax benefits as well. Contribution of Rs 1.5 lakh per annum is eligible for deduction under Section 80C. The interest earned on the investment is also tax free. The total interest earned and the maturity amount is exempt from income tax. Given the falling rate of interest in the economy, there is a likelihood of PPF rates also declining going forward, but they will still be higher compared to bank deposits.
PPF provides an additional source of resource for the government. Investors looking for higher return, safety and tax benefits should look at PPF.
Short Is Safe
For those who want to avoid the hassles of studying various debt schemes, the mutual fund industry offers an array of investment avenues in the fixed income space. They offer a single-point entry for investing in a scheme with a diversified pool of debt securities. Various options are available in terms of returns, risk and liquidity.
"What is not very clear is for how long this phase of low interest rates will continue. If the assumption is that rates will be lower in the near term and could inch up in the medium term, shorter-duration products are much better than locking the money for a longer term (seven to eight years)," says Varadarajan of Tata Mutual Fund.
Ultra short funds are also something that advisers are betting big on. These funds invest in high-quality debt paper of the government, PSUs and companies for a period of three to six months. "There is no credit and interest rate risk in these instruments," says Varadarajan. There are best rated funds such as Aditya Birla Life Savings Fund, Tata's Ultra Short Term Fund, SBI's Magnum Ultra Short and Kotak Savings Fund. If someone wants to go slightly longer within the near term, the money market mutual fund option is there to park funds for a year. These funds offer slightly higher yields because of their exposure to corporate than PSU bonds. They generate 7-8 per cent return, and can be a good option along with fixed deposits.
Credit risk funds, popular among investors during the pre-IL&FS days due to high returns, are something that wealth advisers are cautioning against. These funds take a risk by investing in corporate bonds with credit ratings below the highest investment grade. "The credit environment is challenging. Downgrades are rising. The moratorium and forbearance also indicate the stress in the corporate sector," says a wealth adviser.
The perception among investors is that the debt market is risk free. But that is not the case if you are shopping for higher yields. "Everything is not issued by the Government of India or comes with a guarantee," Cheruvu of Validus Wealth cautions.