No matter how savvy an investor you are, a little certainty of returns from the investment portfolio adds to your comfort. If equities give wings to your portfolio, fixed income instruments offer stability and certainty.
Therefore, it is important to have a right mix of debt and fixed income investment options in your portfolio.
Prateek Solanki, a 32-year-old college professor, had been thinking of consolidating his debt portfolio. He had some money in bank fixed deposits, and some of his money was in Public Provident Fund (PPF). He is now trying to diversify his debt portfolio.
Let’s look at how Prateek can allocate his debt investments.
Fixed deposits
Bank and company fixed deposits can be useful investment options if Prateek has any financial goals to achieve in three years. They offer a fixed interest, and protect one from future uncertainty. Bank FDs can have tenure of anywhere between 45 days and 10 years, while company FDs usually have 6-60 months tenure.
As they have fixed tenure, Prateek may not be able to withdraw the money whenever he wants despite the fact that most FDs have premature withdrawal option. Interest from FDs is taxed as per an individual’s tax bracket.
Liquid funds
The liquidity issue that Prateek faces with FDs can be avoided either by keeping the money in savings account, where he can earn 4% (barring few banks which offer up to 6%) interest or by going for liquid funds, which can earn 7-8% a year. Money from liquid funds can be redeemed any day and money is credited in the account of the investor within 24 hours.
In terms of taxation, if redeemed within three years of investment, any capital gains from liquid fund are taxed in the same way as the interest earned on FDs. However, if redeemed after three years, the capital gains is taxed at 20% after adjusting the investment amount by inflation.
Liquid funds are clearly a much better option than keeping your money in savings account.
Short-term accrual funds
This is a category of mutual funds that invests in short duration corporate bonds and money market instruments. The main feature of these funds is that they generate income mostly by holding low-duration high-yield bonds or debt securities. Their low duration ensures that the downside risk in case of increase in interest rate is limited. And the high yield ensures good return.
These are good investment options as one gets better returns than FDs by taking minimum risk. Ultra short-term funds and short-term income funds and fixed maturity plans (FMPs) are examples of such funds.
Duration funds
High duration funds are very good investment options when the interest rates are likely to decline. These are high risk funds, but if invested when interest rates are declining, they can give double-digit return.
Tax-saving bonds
These are usually long-term bonds issued by government-approved infrastructure companies. The interest earned on these bonds is tax-free, and therefore, are very attractive investment option. The interest rate is usually similar to government bonds of similar tenure.
For Prateek, who falls in the 30% tax bracket, these are very good investment options compared to long-term FDs. For instance, if he invests Rs 1 lakh in a tax-free bond that offers 7.5% annual interest, and a bank FD, which is offering 8.5%. After-tax return from FD is Rs.5,874, while that from tax-free bonds is Rs.7,500.
Public Provident Fund and Employee Provident Fund
These are the two of the best fixed income investment options. The reason being they are not only completely tax-free—no tax applicable on interest earned and withdrawal amount—the contribution made is also eligible for tax deduction. These two features make EPF and PPF returns comparable to equities.
As PPF offers 8.7% interest and factoring in the 30% tax saved on the amount deposited in PPF every year, the tax-adjusted return is as high as 12.5%.
However, they are long-term in nature. While PPF has a minimum lock-in of 15 years, in case of EPF the money can remain in your account till you retire.
Add spice to the portfolio
Prateek’s debt portfolio comprises only traditional invest options such as PPF, EPF and bank FDs. However, a few smart changes can add the missing zing to his debt portfolio. He should shed his investment inhibitions and start allocating some money to debt mutual funds, which can spice up his returns even in fixed income portfolio. A little risk is worth it when the trade-off is against extra returns of 200-300 basis points (2-3%).