The Hindu Business Line : Giving debt its due

Until recently, the question of how you should allocate your money among various debt instruments was a no-brainer. Small-saving schemes, backed by government guarantee, were the islands of relatively high returns within the debt universe.

Therefore, if you were willing to accept the long lock-in periods under small savings, they were your obvious choice. If liquidity was your priority, you simply invested in debt mutual funds, and were content with lower returns. However, all this has changed over the past year with three key factors necessitating an overhaul of your debt portfolio:

Sharp spike in interest rates: A steady increase in policy rates by the Reserve Bank of India and tight liquidity conditions have contributed to a significant 150-200 basis point increase in market interest rates over the past six months, especially on short-term debt instruments such as certificates of deposit. This has resulted in a significant increase in returns from market-linked options such as short-term debt funds and bank deposits over a six-month period. Under the changed circumstances, there may be no need for investors to lock into a debt option with a long lock-in period in order to earn high returns.

Changes in taxability: With interest receipts from most small savings schemes coming into the tax net, removal of 80L benefits on bank deposits and the proposed hike in dividend distribution tax on certain debt funds, it is more important than ever for investors to factor post-tax returns into their investment decisions, while making their debt allocations. An investor in the 30 per cent tax bracket may need to have quite a different mix of debt options in his portfolio, compared to one in the 20 per cent or nil tax bracket.

Inflation: Climbing inflation rates (up from 4.7 per cent to 6.1 per cent in six months) make it necessary to make sure that your debt investments are earning a reasonable "real" return, net of inflation. Therefore, there is now a greater need to allocate some part of your portfolio to market-related debt options that allow you to benefit from rising interest rates.

So what are the key debt options available to you and how should you choose between them? The following suggestions, based on prevailing returns offered by different debt options and the tax status of each, may be helpful:

Short term: If your investment horizon is less than a year, the key debt options available to you are bank short-term deposits, fixed maturity plans (FMPs) from mutual funds for 90 day tenors and liquid/money market funds.

Of these options, fixed maturity plans (currently offering indicative annual yields of anywhere between 8.5-10.75 per cent) appear to win hands down, irrespective of your tax status.

Assuming you invest in the dividend options of these funds, you could stand to earn post-tax returns of 7.4-9.4 per cent after deduction of dividend distribution tax. This compares favourably to post-tax annualised returns of about 4.5-5.5 per cent on bank deposits of less than a year and 5-5.3 per cent on liquid/money market funds.

In fact, since FMPs for shorter terms such as three months presently offer yields that are in the 10 per cent range, you may benefit from keeping close track of such launches and investing in them whenever the opportunity arises.

Medium term: If you have an investment horizon of between one and three years, the toss-up is between the special deposit schemes offered by banks, FMPs with a 13-month tenure and short-term income funds/liquid funds.

If any-time liquidity is not a priority, you could allocate a lion's share of your portfolio to special deposit schemes from banks or one-year FMPs, sweeping the rest into short term income or liquid mutual funds.

While the standard bank term deposits usually offer lower interest rates, several banks today have a "special deposit schemes" with one-two-year maturities (for 370, 390, 590 days, and so on) that offer a higher annualised return.

While annualised returns on the 370-390 day options currently hover at about 9.3 per cent, those on 590-day options are about 10.1 per cent.

For those in the 30 per cent tax bracket, these translate into post-tax returns of 6.1 per cent and 6.7 per cent respectively and, for those in the 20 per cent bracket, the returns would be 7.1 per cent and 7.7 per cent. If you would like the flexibility to withdraw your money at any time, you could consider mutual fund options such as floating rate funds and liquid funds.

Opting for the growth option of such funds would be more tax-efficient, as your interest would be taxed at the long-term capital gains rate of 10 per cent.

Long term: Small savings schemes such as the National Savings Certificates, Kisan Vikas Patra and the Public Provident Fund, apart from five-year tax saving bank deposits are the key options in this space. However, in current market circumstances, investors with an active approach may benefit from putting the lion's share of their debt portfolio into short- or medium-term debt options. This is because of two key factors.

One, given the scenario of hardening interest rates; it may be better to retain the flexibility to "reset" the interest rates on your debt portfolio at a later date, by going in for shorter-term options at this juncture.

Two, the recent spike in interest rates has been more pronounced for short-term rather than long-term debt. Short-term debt options currently offer returns comparable to the "five-year-plus" options and there may be no need to lock into long-term options to earn better returns. However, if you are a relatively passive investor and would not like to review your portfolio at frequent intervals, culling out tax-saving deposits offered by banks with the best rates, appears the better option.

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