In the article “ Understanding Debt-And how it is different from Equity” we had discussed the basic elements of Debt. We use Debt investments for safety of capital and steady income, and Equity for growth. We had also discussed in “Asset Diversification-The Key to Balancing Risk & Return” the importance of having adequate proportion of investment in Debt in order to balance risk and return. Having understood the meaning of debt and its importance in the overall portfolio, we can move on to talk about the various debt options in little more detail.
We can group all options available under the umbrella of Debt investments into three categories. These are Savings/deposit schemes, Securities and Debt Mutual Fund Schemes.
Savings/Deposits Schemes
We all know of the basic savings account and the Fixed Deposits which can be opened with banks, post offices or coo-operative societies. National Savings Certificate(NSC) and Public Provident Funds are sort of deposits with the government. We can also make Deposits with Non-Banking Financial companies. The peculiar feature of these schemes is that they provide defined income over a defined period of time. There is however, no growth in the invested/deposited principal amount. They differ in the interest rates/returns that they offer corresponding to a period and the tax treatment of the income.
There are some with complete tax exemption on income like PF/PPF. But we can subscribe only up to Rs 1.5 lakh per yr in PF/PPF accounts. There are some partial tax exemptions like on interest in savings account up to Rs 10,000/- under Sec 80 TTA. There are specific schemes and provisions to give additional benefits to senior citizens. One should go through the tax provisions in every year’s budget to understand the implications on own debt investments.
We can withdraw money from savings account anytime without any penalties. Other instruments would permit withdrawal at either some penalty, or at the cost of some benefits which would have to be foregone. While evaluating options one must compare the annual post tax return and penalties, if any, on early withdrawal. Deposits in smaller banks and NBFCs is not advisable, even if they offer attractive returns and other bundled benefits.
Debt Securities
Securities in basic sense are documents/contracts pertaining to a financial asset. The feature that distinguishes them from the previous category is that they are marketable. Each security has a specific coupon rate (interest rate) and tenure associated with it. The holder can sell it before the tenure gets over in a secondary market like the exchange. These are generally in the form of Bonds, Debentures, Commercial Papers and Certificates of Deposits etc. The gains are primarily in the form of assured pre-defined income, as well as gain in the price of security. Increase in price happens if the interest rates move in favorable direction.
Earlier, transactions in securities were possible only for large players and financial institutions as the minimum capital required was large. It is now possible for retail investors to trade in securities through exchanges. The draw back for retail investors however is that the interest component of income is taxed at marginal rates. This would generally be the highest applicable rates. The benefit of indexation is also not available. Further at the moment liquidity of Debt Securities is very less. This means non-availability of a buyer at fair rates when required.
Some Infrastructure Bonds provide tax benefits, if you invest capital gains from property sales up to specified amounts. The returns in such investments are however very less. Also, the lock in period restricts availability of these funds for deployment in better options. From time to time Government also raises funds by issuing bonds with some tax benefits. These can be subscribed to, if the combined return and tax benefit is better than the other schemes. Other than the specific Securities, and occasions when some tax benefit is available, this category is not of much advantage to a retail investor for direct investment.
Debt Mutual Fund Schemes
The category of Mutual Fund Schemes as Debt Investments is of great interest and relevance to retail investors. First thing to understand is that Mutual Funds are organized as a Trust, with the investors as its beneficiaries. This solves three problems of the retail investors while making direct investment in Securities. The first problem is of the scale, which the Mutual Fund Scheme solves by pooling in money from all the retail investors. The Scheme thus gets a capital of meaningful size for investment in Debt Securities. The second problem solved is of liquidity, wherein it is extremely easy to redeem holdings from a Mutual Fund. Investors can operate it almost like a bank account. And the third, and very important issue which Mutual Funds solve is of Tax.
Direct investment in Securities entails taxation of interest component of income at applicable rates. But by investing in the same securities through Mutual Fund Scheme the interest income is transformed to capital gains. We have discussed in “Tax Planning & Tax Efficiency“ how taxation of capital gains from different assets including debt investment differs.
Mutual Funds provide a diverse spectrum of various schemes to cater for various investor needs. They provide the required diversification within Debt class. This helps investors to plan for their requirements of regular income as well as capital appreciation. They permit planning in a manner which is more tax efficient as compared to other debt categories/instruments.
Conclusion
The basic understanding of the nature of Debt instruments and the various categories is essential to identify the correct asset/instrument in individual context. This understanding would help investors relate to the diverse categories of Debt Mutual Fund Schemes available in the market today.