Time to Move from Bank FDs to 100% Debt Mutual Funds

Time to Move from Bank FDs to 100% Debt Mutual Funds

It is impossible to produce superior performance unless you do something different from the majority- John Templeton

India has a household savings rate of around 30%, even though it is a relatively low-income emerging economy, but a stock market participation, including the debt market, of under 2%.

This includes the investors on a direct basis, and those via mutual funds. And this meagre total is from a population of over 1.2 billion.

While this percentage has not changed, even after the liberalisation of the economy of 1991, it may be time to reconsider, without having to take on any appreciable risk in the process.

The 5/4 star rated, 100% debt-oriented mutual funds, are going to prove better investments than bank fixed deposits going forward. This, particularly in the declining interest rate scenario, being promoted vigorously by the finance minister at present.

The time lines to this policy direction may become clearer once the new RBI governor gets his or her feet under his Mint Road table.

 All 100% debt funds hold a diversified portfolio of top-rated company debentures and government bonds to make up their number. And they now come in a wide array of choices: liquid funds that invest in very short-term debt instruments, often of just three-months duration or less; others are at short, medium, and long tenures, ranging from six months to 10 years.

When interest rates rise, the short term and liquid funds perform better, and when they fall, the longer term income funds produce better returns. This is for a number of fairly complex reasons, best understood by economists.

For the foreseeable future, interest rates too, as determined by the RBI, will keep grinding lower, alongside other measures to improve the liquidity in the financial system, as an ‘easy money’ policy overturns the erstwhile ‘tight money’ stance, used, not very effectively, to try and curb inflation, in the recent past.

Inflation  did indeed come down over the last 25 months, but mostly on the back, and lucky happenstance, of vastly lower petroleum prices. It bettered the fiscal and current account deficits in the process as well.

 The policy need to cut interest rates stems from an urgent requirement to stimulate growth in the private sector, both manufacturing and in services, enhance job formation, and wake up the moribund housing construction sector.

Others who will be glad, the home-loan borrowers, car/appliance/student loan availers, the SMEs, consumers, start-ups,  business/industry that wants to add capacity, and so on.

 All debt funds, even the ‘close-ended’ ones, with a 3 year lock-in, are diversified, to contain, on average, between 10 and 20 different debt instruments. This is also in keeping with the regulatory environment, created by SEBI, mandated to protect the interests of investors.

The open-ended, growth option, debt mutual fund however, is the best bet for the retail investor. These can be bought or sold on any working day. Pay-outs are made within just three days.

This means that even sudden, or planned monthly requirements, can be withdrawn at will, normally qualifying for no tax, and without having to wait for a taxable dividend, applicable on 100% debt funds.

All debt funds, by their very composition as fixed interest instruments, do not go up and down in value dramatically - like shares do. They rule steady, and return anywhere between 5 to 10% per annum, depending on the category chosen, but are certainly more tax efficient than bank fixed deposits.

The tax on their profits is capped at a rate of 20% , provided they are held for three years. Early withdrawals require the profits, which tend to be minimal, unless the sum invested is vast, to be added to taxable income from other sources, and taxed at the marginal rate applicable .

This, theoretically is at about 33% in the highest tax slab, except for the few declared annual crorepati earners, who’ve had yet another tax slapped on them lately by the NDA.

 This duration to qualify for long-term capital gains, on debt mutual fund investments, was upped in 2014, by Arun Jaitley, in his very first full budget.

Before that, these debt funds were more attractive, because they went from being short-term capital gainers, for tax purposes, after just 1 year, into long-term capital assets.

And these were taxed at a flat tax rate of 10% initially, which was increased to 15%, and finally, in 2014, to 20%, albeit on an indexable basis. This, just like proceeds from real estate/property sales.

The one year qualifier was extended to three, in 2014, but for securities held longer still, the inflation indexing benefits, quite often, ensure that tax calculations end up at nil.

So, a debt fund investment held, say, for 10 years, and now worth more than double with the compounding effect, will be tax free on withdrawal in full, because of 20% tax rate, duly indexed. Of course, the law/provision could change, as it has in the past, but the principle, as of now, is very clear.

It is also permitted by the RBI to pledge these debt funds freely to any bank. An individual can pledge up to Rs 20 crores, and borrow up to 90% of their value, at a rate of interest pegged to reference the RBI’s lending rate, revised from time to time. You can borrow currently in the range of 10.5-11% and earn, sometimes more than your borrowing cost, at next to no risk.

Contrast this with a ceiling of Rs. 20 lakhs maximum, per individual, against equity, no matter how much there is to pledge,  at no more than 50% of the market value, with a commitment to make good any precipitous drops in value within 48 hours.

Equity is not good security to borrow against, though as an investment for those with a long term perspective and patience, the returns can be much more rewarding than debt.

The scores of debt mutual funds on offer today, are all rated by CRISIL ,Value Research, Economic Times, Moneycontrol, etc., provided they are 3 years or more old. This so that they provide an adequate track record.

Their star ratings, reviewed monthly or more frequently, and their logic, even for those funds that are not yet mature enough, are all freely researchable on the Internet, in newspapers, or on the business oriented news channels.

And though there are many financial advisers, both with the banks and elsewhere, it is quite possible, for those with a sufficiently financial bent of mind, to invest directly, thereby saving on brokerage and commissions.

Bank FDs, on the other hand, are not only static once one they are locked into a return stated at entry, but taxed at the marginal tax rate from the start. They are also earmarked for more tax at the time of filing one’s returns, by the TDS up front.

Till a few years ago, the Indian investor did not have the myriad options that are available today.

In 1963, the government established the very first mutual fund, initially via the Reserve Bank of India (RBI). The Unit Trust of India established a monopoly with its one-trick pony named US- 64, and this ran on and on, eventually garnering about 11,500 crores off  about 2 crore small investors, and handing out above average dividends for years. This, till it came to grief, from the late nineties, aagain for multiple reasons, and is now closed.

US-64 was joined, in 1987, by other PSU bank mutual fund offerings from the SBI, Canara Bank, PNB, and so on. Then in 1993, private mutual funds with highly professional foreign partners, from the multi-billion dollar US MF industry, were also allowed into the country.

And though small, with a market capitalisation in the region of half a billion dollars in 1994, and no more than $ 2 trillion now, the Indian stock markets were early movers, becoming automated in 1994-95.

Today, per statistics up to March 2016, there are 11,856 mutual fund schemes to choose from, provided by 43 fund houses. Collectively, they manage Rs. 106,30,921.82 lakhs, in retail/institutional/corporate investments.

FIIs, who probably understand the business better, have a bigger holding  of the liquid, non-promoter held stock in India. They hold 10.45% of the  listed shares. Indian mutual funds account for just 2.68%. And other Indian financial institutions hold another 5.32% .

After all this time, there are just 20 million demat accounts, and some 248 listed portfolio managers.

Mutual funds, plus all the direct participation in the stock markets, represent a fraction of the personal savings of Indians. These stood at 22,124.14 billion in 2013, up from Rs. 20,547.37  billion in 2012, as per the Ministry of  Statistics &Programme Inplementation (MOSPI).

The International Monetary Fund (IMF), states that the Indian household savings rate was at its highest in 2011 at 34.7%. It was at 30.17% in 2014, is expected to decline to 28.35% by 2018, before rising once again to 28.6% by 2020.

Moves are afoot on the part of the government to deepen the Indian debt market. Whatever has been done so far, has been eagerly lapped up by the FIIs, who invest more in debt than they do in equity, if not the locals.

The equity market too has seen a recent spurt in initial public offerings (IPOs), largely gone missing for a long time. With banks under- capitalised, and burdened by NPAs, the debt market becomes all the more important as a source of capital.

The SMEs certainly need the debt market but so do the bigger companies and most importantly, the Government of India. The government largely lives and grows on its borrowings from the debt market. And every kind of corporate body/institution looks towards buying/selling its  shares in the secondary market and raising funds in via the primary equity markets.

While overall, our stock market capitalisation does mirror the size of the official economy, not counting the black money sloshing around, our debt market is still, when it comes to government gilts, for example, largely illiquid.

And, despite some reform undertaken, not very large, in international terms. Great strides in modernisation, a mandatory deepening, and widening, is necessary, of course.

It is certainly a case, for those in the know, that a developed financial market, can, and does, receive many multiples of the FII investment that India is able to attract.

And this in all categories, including futures and options, and derivatives, the latter trade, hardly having begun in this country.

The international investment portfolios run into more than $35 trillion per annum. So the sky, indeed the stratosphere, is the limit - both for domestic investors and foreigners. Moving some of our savings from FDs into debt funds in larger numbers, could be a start in the right direction.

For: The Sunday Guardian

(1,787 words)

July 13^th, 2016

Gautam Mukherjee