What is Debt Market?
Are you are an investor who is risk averse, but looking for returns better than bank deposits, then debt investment could be the best option for you.
If you look beyond the traditional fixed deposits, there are a host of other debt invest options which are available to investors depending on their requirement and tenure. This article aims to explain the basics of some of these products.
What is Debt Market?
The debt market is the financial markets where investors trade in debt securities or debt instruments. So what is debt?
What is Debt?
Debt comprises of money borrowed by an outside party for a certain period of time to meet any requirement. Obviously the person lending the money expects a return on the same, and this is paid out in the form of interest.
There are a few parameters which you would need to look at while judging what option to pick from the basket of products available. These would be yield, taxation, duration, lock in period to name a few.
The underlying securities in which the fund would be invested are issued either by the government or by companies. The risk of default is obviously lower in government securities, though their returns would also be a bit lower.
Debt Investment Options
Let us look at the choices available:-
Option #1 : Fixed Deposit
Fixed deposits are debt investments with a pre defined tenure and rate of return. They are arguably considered to be the safest form of investment for majority of Indians.
Though they generally do not have a lock-in, but premature withdrawal reduces the rate of return. The rate of return tends to be higher for longer durations, though it is not necessarily so at all times.
Fixed deposits can be issued either by banks or by companies. The taxation on Fixed Deposit though is inefficient as they are added to the taxable income of a person and taxed according to the slab they fall in.
Option #2: PPF and NSC
Two of the safest forms of long term debt investment are Public Provident Fund (PPF) and National Savings Scheme (NSC). Read How to invest in PPF and benefits of PPF here
These are schemes run by the central government to encourage a saving habit among the fixed income group. Both the schemes have a definitive lock in period. While NSC has a 6 years lock in, the duration for PPF is 15 years. They do provide options of partial premature withdrawals subject to certain conditions.
The returns on PPF are 8% p.a. and amounts range from Rs. 500 to Rs. 70,000 per year, and an account can be opened through the post office or nationalized banks.
The amount invested in PPF is eligible for deduction under section 80C of I.T act, wherein the amount is deducted from total taxable income of an individual. The returns are also tax free, and that’s what makes them very attractive for long term investment.
Similar in nature, the NSC also have a rate of return which is 8%, but it is compounded half yearly. The investments made in NSC are also eligible for deductions under section 80C; however the returns are taxable as per one’s tax slabs.
Option #3 : Debt mutual funds
The mutual fund route also offers a range of debt investments for individuals, depending on one’s risk appetite, duration and with varying returns on them. The options under debt mutual funds are listed below.
a) Gilt/Income funds
Gilt funds invest in government bonds of a long tenure, with an average maturity of 7-10 years.
These are obviously very safe as they are backed by government of India, however due to the long tenure they are subject to interest rate risk, and the value of bond holdings could decrease if interest rates rise in the future.
However, they do provide a regular source of income through dividends which are declared consistently every year.
Income funds are similar in nature, though the investments here are more in long term corporate debentures. They do carry a certain amount of default risk/credit risk depending on the credibility of the issuer.
Most of these funds would have an exit load in held for less than half a year.
Both of the above mentioned funds have variations in NAV which could provide steep upwards or downward returns, apart from dividend income.
b) Short term funds
Short term debt funds invest in bonds or debentures which are not very long in duration. The average maturity could be anything between 1 to 2 years. They also declare dividends periodically, and are ideal for customers looking for an investment horizon of about a year.
The exit loads vary from 3 to 6 months, and the interest rate risk is much lower in these products. Roughly, returns on short term funds would be close to 7% per year, and they are not a bad investment option for risk averse investors.
c) Liquid funds
As the name suggests liquid funds are meant to maintain client’s liquidity while offering better returns than bank deposits. The average maturity of these funds is much lower at about 45-90 days, as they invest in treasury bills or short term debt papers.
The fluctuations in NAV of these products are very miniscule and the returns tend to be 1-2% higher than bank accounts. The idea here is to park your funds while deciding on better opportunities or with an idea of maintaining the liquidity.
The funds have no entry or exit loads and can be liquidated at any point of time.
d) Fixed Maturity Plans
The concept of a fixed maturity plan is not entirely different from a fixed deposit. The products have a fixed life, after which the amount has to be repaid with the interest. The amount has to remain in the fund for the entire duration and premature exit would invite quite large exit loads.
They offer fairly decent returns, often exceeding return on fixed deposits by a small margin. Durations range from above a month to 3 years or more.
e) Hybrid funds
Debt based hybrid funds comprise of a mix of debt as well as equity investments, though majority of the amount is in debt. Commonly they are called Monthly Income Plans (MIP), as the idea is to generate a small monthly income for the investor.
The average maturity of the debt instruments is also not very long, and the primary aim is to use equity to boost the returns on debt. A well performing and consistent MIP would be able to deliver double digit returns at most times.
The taxation on debt mutual fund remains the same across all these categories, and there are two ways of taxing the returns. While capital gains or fluctuations in NAV are liable for a capital gains tax, the dividends declared draw a dividend distribution tax.
Long term capital gains are at 10% without indexation and 20% with the benefit of indexation. The time duration of investment must be greater than a year to be classified as long term. Dividend distribution taxes on the other hand are taxed at 14%, and are deducted at source while declaring the dividends.
Depending on one’s duration of investment and the tax slab, the decision of opting for growth or dividend option has to be made.
Option #4 : Structured Products
Structured products come in the form of basket linked debentures. They are not pure debt products and are generally have a certain component linked to the equity/commodities market. The common style of functioning is to have a pre determined condition based on which the returns would be paid out to investors.
They have a fixed lock in period equal to the duration of the product itself. Such structured products are issued by private financial bodies and comprise of securities issued by corporate.
They may or may not be capital protected schemes. In some cases they even guarantee a minimum rate of return. But due to their wide variations, it’s very difficult to generalize their features. The tax payable is again added to one’s taxable income and is liable as per their tax slab.
Option #5 : Debentures/Bonds
Instead of going through a mutual fund route, investors can opt to directly purchase bonds/debentures also from the secondary markets. The duration again would be prefixed, as will be the rate of return. The returns are taxable as per the tax slabs and the bond value varies depending on the issuer. These would be subject to interest rate risk depending on the duration of the bond.
Certain tax free bonds also provide tax saving options for clients, and specified infrastructure bonds offer investors an opportunity to save up to Rs.20,000 p.a. from their taxable income.
Though each of the products discussed have a lot more intricacies, the basic idea here was to showcase the entire gamut of debt products available to an individual investor in our country.
One should analyse what they are looking for from their investment before making this choice, and considerations of risk, return, duration, liquidity, taxation etc have to be made before choosing where to put your hard earned money.