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Save in fixed-income instruments to balance out equity volatility

Part of your savings should be invested in fixed-income instruments to stave off the risks inherent in equity instruments.

Dipak Mondal/Money Today | Print Edition: April 2011

The swinging stock indices can give anyone sleepless nights, especially with a portfolio overexposed to the stock market. Though equities are essential investments, their proportion in one's portfolio should be based on one's risk appetite, investment goals and age. A prudent counter could be to have a fair share of fixed-income instruments in your portfolio. In fact, now would be a good time to increase your holdings in debt instruments, with interest rates on the rise and a good variety of products to choose from.

HIGH INTEREST RATES

Interest rates are already considerably high and a probable increase in benchmark rates by the Reserve Bank of India (RBI) could help bank fixed deposits rates move further northward. The current fixed deposit rates are in the range of 8.5-9.5%.

8.5-9.5% is the current interest rate range for bank fixed deposits, which could rise further.
Bond prices are also likely to inch upwards following budget announcements of a lower than expected fiscal deficit. The government usually funds fiscal deficits by issuing bonds and a low fiscal deficit number means fewer bonds issued, which, in turn, would keep bond prices firm.

Laxmi Iyer, head of products, Kotak Mutual Fund, says bond prices are lucrative at the moment. "Low government borrowing estimates is positive for the bond markets in the short term," she says. Investors would also have an avenue to invest in fixed-income instruments coming from infrastructure finance companies with the government extending the scheme under which investment up to Rs 20,000 in infrastructure bonds of approved companies will be eligible for tax deduction over the existing Rs 1 lakh limit.

Apart from these, investors in 2011-12 would have the option to invest in tax-free bonds to be issued by government-owned infrastructure companies. The government has allowed four PSUs to issue these bonds worth up to Rs 30,000 crore in 2011-12.

OPTIONS AVAILABLE

Fixed income options available in the markets can be broadly divided into three categories-bank and corporate FDs, corporate or government bonds and mutual fund fixed income schemes. We have evaluated these options in terms of return, tax liability, liquidity and risk.

Bank and corporate FDs: One of the most favoured investment options among Indian investors has been fixed deposit schemes of banks and corporate houses. One of the benefit, especially for bank FDs, is that returns are guaranteed and do not carry any market risk. At present, with high interest rates, most banks are offering 8-9.5% on one-year FDs.

However, the interest earned from fixed deposits is not tax-free and is taxed as per the investor's tax slab. "FDs are ideally suited for people in the lower tax bracket or those who are nearing retirement or are already retired," says Swapnil Pawar, chief investment officer, Karvy Private Wealth. Bank FDs with a 5-year lock-in are also eligible for tax deduction under Section 80(C) of the Income Tax Act. However, the interest rates are lower on these schemes. Corporate FDs, on the other hand, offer 1-2% higher rates of interest than bank FDs. But investors should avoid company FDs that do not carry a high rating or are unrated but promise lucrative interest rates - some as high as 15%.

Srikanth Meenakshi, cofounder, fundsIndia.com, an online distributor of financial products, says it would be prudent not to chase returns while investing in corporate FDs. "Even if returns are lower, it would be better to go with schemes that have a good rating and a solid track-record," he says. In case of both bank and corporate FDs, there is an option of premature withdrawal. However, in case of early withdrawal, issuers lower the rate of interest by 1% from the original rate.

"Taxable bonds are best suited for HNIs, who are in the highest tax bracket (30%) and hence tax-adjusted return is higher for them."
Anil Rego
CEO, Rights Horizon
Corporate bonds/NCDs: Big companies supplement their funding needs by raising money through bond issues.

Usually, interest earned from these bonds are taxable, the government at times allow some companies to issue tax-free bonds for retail investors. Interest earned from bonds are taxed as per an individual's tax slab.

SBI recently issued taxable bonds with the target of raising Rs 750 crore from individual investors-retail as well as HNIs. For 10-year bonds, the bank offered 9.75% annual interest and 9.95% for a 15-year bond.

Karan Bhagat, CEO, IIFL Private Wealth Management, adds a word of caution. "Investors need to be aware of the capability of the borrower to repay back the funds at the time of maturity. Senior citizens and conservative investors should choose highly rated and strong institutions, such as SBI," he says. The government in its budget allowed four PSUs to issue tax-free bonds of up to Rs 30,000 crore in 2011-12. The PSUs include the National Highway Authority of India (NHAI), the Indian Railway Finance Corporation (Rs 10,000 crore each), HUDCO and Ports (Rs 5,000 crore each). NHAI is expected to come out with the first tranche of bonds in May.

Anil Rego, chief executive officer, Rights Horizon, says the interest on tax-free bonds are lower than that of taxable bonds. "These (taxable) bonds are best suited for HNIs, who are in the highest tax slab (30%) and hence tax-adjusted return is higher," he reasons. (See Tax impact on earnings from bonds)

Long-term infrastructure bonds, for an additional income tax deduction of Rs 20,000 under Section 80C, would be issued again in 2011-12. Last year, these bonds offered rates of 7.5-8.5% for a period of 10 and 15 years with call options after five and seven years respectively. Mukesh Dedhia, a certified financial planner, says: "A person in the highest (30%) tax slab, investing Rs 20,000 in such bonds paying 8.30% cumulative interest after 5 years (assuming the call option is exercised), would get Rs 29,797, a tax-adjusted yield of be 16.31% annually. For individuals in the 20% and 10% tax slab, the yields would be 13.24% and 10.61% respectively."

Fixed income mutual funds: These are tax-efficient and welldiversified across debt instruments. Financial planners agree schemes such as fixed maturity plans, short term debt funds and gilt funds are ideal, given the current interest rate and bond market scenario.

Fixed maturity plans (FMPs) are close-ended debt funds with varying maturities. Since these schemes invest in debt papers with maturity not more than their own maturity period and are closeended, interest risk is minimised.

Gilt funds invest in government securities, while short-term debt funds invest in debt papers with a maturity of up to one year.

FMPs are popular schemes because they offer returns close to or better than bank FDs, have a wide variety of maturity options (3 months to 3 years) and have double indexation benefits.

"FDs are ideal for people in the lower tax bracket, those who are nearing retirement or are retired."
Swapnil Pawar
Chief Investment Officer, Karvy Private Wealth
Funds often launch FMPs that have a maturity period of 370 or 390 days. These help investors take the benefit of double indexation (See Benefits of Double Indexation). Indexation is adjusting your tax liabilities to inflation. In double indexation, the capital gain is adjusted for inflation twice, once in the year of investment and then in the year of maturity.

On the flip side, debt mutual funds do not offer guaranteed returns. Change in interest rates can lead to fluctuation in returns.

Hybrid or structured products: Many mutual funds and private banks also offer hybrid products with a majority holding in debt instruments and a small exposure to equity and derivatives. These include debt-oriented hybrid fund schemes, such as capital protection funds and monthly income plans. These offer capital protection through high debt exposure and capital appreciation through small equity investments. However, derivative-based structured products are yet to become popular and are mostly used by HNIs.

Though fixed income savings instruments may not give very high returns, the low risk and tax benefits do attract many investors. Financial planners say even aggressive investors should allocate 20-40% of their savings in fixed income instruments. This may be the best of times to do so.

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