As the nation awaits formation of a new government at the Centre, the stock market is on fire. However, investors are facing the dilemma of what to do in the current market scenario.
While on one hand, there are investors who are wondering whether this is the right time to exit, on the other hand there are investors who are debating whether they can take the plunge now.
While investors' struggle to untangle these dilemmas about their equity investment continues, they need to make a decisive move with regard to their debt portfolio. For a large section of investors in our country, traditional debt instruments continue to be the mainstay of their debt portfolio.
Since the safety of capital remains the top priority, other aspects such as tax efficiency of returns, liquidity and the need to explore market linked products to enhance overall portfolio returns are often ignored.
Although safety of capital has to be a priority, it is important to put it in proper perspective. The right way to manage investments in different asset classes is by creating the right balance between risk and reward. In other words, investor must realize the need to focus on real rate of return rather than nominal return.
While the nominal return represents the growth rate of money, the real rate of return represents the change in the purchasing power of money. Simply put, it's actually the real rate of return that indicates whether one's money is growing in value or not.
Since most investors invest a major share of their debt investments in traditional options offering lower but guaranteed returns, more often than not, they fail to earn positive real of return.
While it is true that during higher inflation regime investors get an opportunity to earn higher interest on their investments in FDs and bonds, the tax inefficiency of return negates that benefit to a large extent. Therefore, investing in a tax efficient investment vehicle like mutual fund can make a difference to the real rate of return.
Hence, it's time for investors to look beyond traditional options and start investing in options that can yield higher post tax returns.
Mutual funds offer a variety of debt funds to suit the requirement of investors with different risk profile and time horizon. The tax efficiency of mutual funds makes a significant difference to the post tax returns. Moreover, mutual funds have the potential to deliver higher returns than traditional options.
Of course, the key is to select the right fund and manage the credit and duration risk while doing so. Among the debt funds on offer, the major differentiator is the maturity duration of the portfolio. Each category of debt funds has a different risk profile and commensurate return potential. Since there is an inverse relationship between interest rates and bond prices, the longer the maturity duration of the portfolio, the greater is the impact of an interest rate change. Similarly, funds that have shorter maturity durations, experience lesser impact of the interest rate movements.
Therefore, if one wants to invest for a shorter duration, say more than three months but less than 6 months, ultra short-term income funds will fit the bill. Similarly, if the time horizon is six to twelve months or so, short term income funds would be apt. For those who have a time horizon of more than a year, the toss up could be between an income fund following accrual strategy and a medium term debt fund. For those who have a time horizon of 18 months or more and may want accrual returns as well as capital appreciation from lowering interest rates going forward, there is an option like a corporate bond fund. Here, one must opt for funds that have a portfolio with moderate maturity and good credit quality.
Then, there are Fixed Maturity Plans (FMPs). FMPs aim to generate predictable returns and at the same time protect an investor from interest rate volatility. While structurally FMPs are akin to Fixed Deposit, the tax efficiency makes them a much better option for investors in higher tax bracket. However, one must be sure about one's time horizon while investing in FMPs as the liquidity provided through listing, during the duration of the fund, is not an efficient way of exiting from the fund.
Although selecting the right fund is important, the selection of right option, that is, dividend payout, dividend reinvestment and growth is also crucial. For example, investors in 30 percent tax bracket can benefit from tax efficiency by opting for dividend payout or dividend reinvestment for investments made for a time horizon of less than 12 months and "growth" option for investment having a time horizon of more than 12 months. For example, any capital gain arising out of a mutual fund investment after 12 months is treated as long term capital gain. While long-term capital gains on an investment in an equity fund is tax free, investors are required to pay tax at a flat rate of 10 percent for investments in debt funds as against 30 percent for interest earned from traditional options like FDs and NCDs. On indexed capital gains, the applicable tax rate is 20 percent. Similarly, dividends paid by mutual funds are tax free in the hands of investors. However, for dividend paid by a debt fund, the fund is required to pay a dividend distribution tax.
Income funds can also be a good option for those investors who may like to invest on a monthly basis over the short and medium term. Although the general belief is that a disciplined approach of investing through a Systematic Investment Plan (SIP) works only for equity funds, the truth is that it can be a great strategy for debt funds too. In fact, it can be a good substitute to a traditional option like Recurring Deposit.
As is evident, debt funds can make a huge difference to the performance of debt portfolio of every investor. However, the retail participation in these funds, except for a category like FMP, has been very low. Investors will well to begin the process of including debt funds in their portfolio. By doing so, they can expand their investment universe and also give themselves a chance to get higher returns.
(The author is CEO, Wiseinvest Advisors)