The month of March has a special place in investments. There is heightened investment activity due to the last minute rush to “save taxes”. Any product that offers tax benefits is in big demand and the investment flows peak across investment products. The big gainers of these flows are generally debt mutual funds, equity linked saving schemes, Life Insurance, Health Insurance and Public Provident Fund.
In this blog, I would like to share my thoughts on the current economic environment and why debt funds offers a great investment opportunity.
Equity Markets are correcting rapidly!
Finally the equity markets are reacting to negative news. As I write this blog, we are witnessing a sell-off across global markets including India. The stock indices across the world including DJIA (USA), FTSE (UK), DAX (Germany), Nikkei (Japan) and Shanghai Composite (China) are down by 6% to 10% from their recent peaks. The BSE Sensex too has dropped to 38,297 from its recent peak of 42,273 (almost a 10% loss).
We do not know when the markets will rebound but we do know that the economic situation is fairly adverse and there are no signs of any kind of recovery in the near term. The fundamentals of the economy also remain weak and the latest GDP numbers (4.7% for the latest quarter) only add to the gloom.
I do not think it is advisable to change the equity allocations but at the same time it may not be prudent to add to equity at this point in time. Debt investments on the other hand can provide additional stability and also an optionality to move into equities should the market fall further.
Have Interest rates bottomed out in India?
The world has witnessed a slowdown in economic activity and there are even more reasons to be bearish given the situation that is evolving on the corona virus issue. The central banks across the globe continue to remain dovish and many countries in Europe are in the grip of negative interest rates. Is this scenario likely to change? With recession fears gripping the world, there is a view in the market that lower rates might stay subdued for a reasonable length of time in the future.
India continues to remain an outlier in terms of interest rates. The nominal rates in India are not only higher compared to elsewhere in the world but the domestic situation may constrain the Reserve Bank of India to cut interest rates further.
The macro factors that impact interest rates barring a low GDP Growth rate are not supportive of further drop in interest rates. The inflation rate in India has risen sharply with the Consumer Price Index growing to its highest level since May 2014. Refer chart below.
Consumer Price Inflation has risen sharply!
In the recent budget announcements the government has utilized the flexibility provided by the Fiscal Responsibility and Budget Management Act (FBRM) and has budgeted for a rise in fiscal deficit in FY 20-21. This means enhanced borrowings by the government and hence may lead to a rise in interest rates. On the Foreign Exchange front, the Indian Rupee continues to drop albeit lower compared to other currencies. The Indian Rupee is close to the 72 mark and there may be little room to let it drift down further.
Bank fixed deposit rates have dropped significantly
The Bank Fixed Deposit rates have come off significantly in the last one year. Investors are no longer willing to invest in Banks where the perceived risk is higher, specially after the Punjab and Maharashtra Bank episode. State Bank of India currently offers an interest rate of 6% p.a. for a 3 year Fixed Deposit. Given the high rates of taxes for High Net Worth investors, the post tax yield on such deposits is a little over 4%. In a low interest environment, tax efficiency gains more prominence and hence investors should consider investments that are likely to give a higher post tax yield.
Why debt funds now?
In recent months, debt funds have been in news for the wrong reasons. There has been a series of defaults that have hurt investment returns. The investors have been reluctant to invest in debt funds that are perceived to be risky and have moved to debt fund categories like Banking and PSU Debt and Corporate Debt where the underlying exposure is to high quality credit. It is difficult to comment on what lies in store in the future but investors are likely to invest with safety as the top priority. The asset management companies too have started tightening their credit and risk processes to ensure that they minimise the risk of such a situation arising again in the future.
Given the above situation, debt funds that invest in high-credit quality papers, maintain a short duration and are well diversified can be fairly attractive from an investment perspective. The lower duration protects the investor from significant losses should the interest rates go up. Further the debt portfolio gets re-priced as the lower duration investments mature. This can help the funds to re-invest at higher interest rates. The tax efficiency of debt mutual funds adds to the appeal as investors can earn a higher post tax rate, provided they remain invested for at least three years.
Tax Efficiency of Debt Funds
Note: The above example is for illustration purposes only. Key Assumptions: Returns: 7% p.a.; Cost Inflation Index: 4% p.a. and Taxation @ 30%. The actual scenario may be very different from the above illustration.
The above table illustrates the tax efficiency of debt funds. In case of Fixed Deposits, interest income gets added to the annual income of the investor and is taxed as per the overall income slab. For most High Net Worth investors, the tax rate works out to 30% plus surcharge and cess. However, investor in debt funds need to pay taxes on the capital gains. If they invest for a period of 3 years the capital gains are treated as long term capital gains and hence are subject to a lower taxation rate. The long term capital gains tax is computed after adjusting your investments with the Cost Inflation Index and the tax rate on the long term capital gain (after adjusting for inflation) is 20%. This can result is better post tax returns in Debt Funds. Investors can also gain an additional indexation benefit if they invest in the month of March.
The tax rates for long term capital gains in Fund of Funds (which generally invest overseas), Conservative Hybrid Funds and Gold Funds is also similar to debt funds.
Conclusion
The current economic environment has several near term risks that are likely to delay the economic recovery. This may lead to sluggish equity markets in 2020.
There is a natural tendency to invest in lower risk investments in turbulent times. Debt funds can be an option that can be considered by such investors. Debt Funds can add stability to the portfolio and investors with a 3 year plus horizon can leverage the tax efficiency of debt funds to earn higher post tax rates.
