Every investor has different risk appetite. Not everyone is comfortable with equity risk. Within fixed income investors are looking for higher returns, tax efficient structure and safety of capital. Let’s study all the fixed income options one by one. 

Fixed Deposits:

For decades, fixed deposits are the most preferred investment choice of millions of people. Fixed Deposits are safe with absolute predictability of maturity date and maturity amount. 

Currently, the rates are near all-time low for fixed deposit investors. The interest rate offered by country’s largest private sector bank (HDFC Bank) is offering Fixed Deposits (general citizens) at 5.50% to 6.10% for 1-to-10-year maturity. SBI is no different with offerings in the range of 5.45% to 5.65% for 1-to-10-year maturity.

At the same time, fixed deposits are very tax inefficient. Interest income is taxed at marginal rate and hence for high tax bracket investors, post tax returns are very low. Refer the table below.

* Excluding cess & surcharge

The CPI inflation for August’2022 was at 7%. This means, for investors in all tax bracket, the real rate of return is negative. Investors are losing their purchasing power by investing in Fixed Deposits and the magnitude is bigger for investors in higher tax bracket. Irrespective of the time frame, indexation benefit is not available for Fixed Deposits.

Except for the tax-saving fixed deposit which has a lock-in of 5years, liquidity is not a challenge in fixed deposits.

Do fixed deposits have a place in portfolio?

Yes, for emergency funds and for short term goals. It also has a place in portfolio for investors who do not understand the other financial products. It’s safe and returns are predictable.

Corporate Fixed Deposit

Corporate Fixed Deposits offer slightly higher returns than fixed deposits of banks. The higher returns come with extra risk. Risk of Default.

Bajaj Finance, HDFC Limited, LIC Housing Finance, M&M Financial are offering rate in the range of 6.15% to 6.35% for a 1-year deposit. All these issuers are AAA rated and comes from reputed groups. PNB Housing Finance & Shriram Transport Finance, which are rated one notch below the top rating, offers slightly better rate of 6.50% and 6.75% respectively.

Just to remind the readers, corporate fixed deposits have defaulted in past. Most recent case which I can remember is the default of AAA Rated corporate fixed deposits of DHFL. Fixed Deposit holders of DHFL have a lost almost three-fourth of their due amount. So, corporate fixed deposits are risky. Unliked fixed deposits of banks which have a INR 5 Lakh credit guarantee, there is no credit guarantee for deposits of NBFCs.

Liquidity is also restrictive within the first three months of deposit/renewal. This is as per the directions of RBI. Although after three months pre-mature liquidation is possible, generally the terms are unfavourable when compared to Bank FD Loan against Corporate FD is possible. Minimum investment and minimum tenure are generally higher than bank fixed deposit. These deposits are rated by credit rating agency.

Taxation of FD from Banks or FD from corporate is similar. No advantage here.

Do corporate fixed deposits have a place in portfolio?

No, pre-mature liquidation is tricky. Default risk is there.

Non-Convertible Debentures (NCD)

Corporates raise their money either in the form of equity or debt. For debt, corporate mostly raises money by issuing NCDs or more commonly called as bonds.

AAA rated bonds for reputed issuers like HDFC, Bajaj Housing, M&M Financials with residual maturity of 3-5 years are available at yield of 7.50% to 7.80%

Problem for normal retail investors is to source them at fair yield. In India, debt market is mostly over the counter market, it means, not much trading happens on exchange and most of the transactions are first agreed between the parties and then executed through Indian Clearing Corporation.

Lower rated bonds are also available which can offer much higher returns, 9% to 14%, but these comes with much higher risk.

Taxation is similar to that of Fixed Deposits, all the interest payment received are taxed at marginal rate of taxation.

Do NCDs have a place in portfolio?

No NCDs doesn’t make sense for retail investors as sourcing & liquidating at fair value is a challenge. The new age platforms are offering lower rated NCDs, which comes with a lot of risk. NCDs are not tax inefficient. NCDs of highest credit rating (and reputed promoter groups) makes sense for corporate treasuries.

Tax free Bonds

Yields are in the range of 5.2% for residual maturity of ~ 5 years.

Interest received is tax free. These bonds are suitable for investors in higher tax bracket. These bonds are mostly used by High-Net-Worth Individuals to play the interest rate cycle. Some hold the bonds till maturity as well.

These bonds are fairly liquid in over-the-counter market.

Portfolio Management Services - Debt

The structure of PMS is such that investor owns the securities in his/her own capacity. Therefore, PMS doesn’t have any tax structure, taxation of the underlying securities will be applicable. PMS mostly buy NCDs, which are not tax friendly, so it makes no sense to do PMS for fixed income.

Also the minimum ticket size, as per regulations is ₹ 50 Lakhs which is not viable for most retail investors.

Alternate Investment Funds – Credit Opportunities

• Minimum investment of ₹ 1 Crore, retail cannot afford that much amount to put in one investment.

• Mostly in Category II structure, close ended, so liquidity will not be there, and taxation is passed on to the investor and will be as per investor’s marginal rate.

• Profit sharing is on pre-tax returns, which becomes substantial portion of post-tax returns.

These kind of investment vehicles are not for retail investors, infact anyone with less than 25-50 Crore of investible surplus, should ignore this.

Market Linked Debentures (Listed)

HNIs mostly do AAA rated 18–36 months MLDs. Some exposure is also taken in AA+/AA rated issuers as well. Some decent lower rated NBFCs also get some allocation.

Here, MLDs are issued mostly on private placement basis and hence minimum ticket size is ₹ 10 Lakhs.

Below is the taxation for three different conditions:

1. Investor sold the product before 1 year, in this case, all the gains will be treated as Short Term Capital Gains and will be taxed at marginal rate of the investor.

2. Investor sold the product after 1 year, in this case, gains are treated as long term capital gains and are taxed at 10%.

3. In case the investor holds the instrument till maturity, differential between buying price and maturity proceeds will be treated as interest income and taxed at marginal rate of taxation.

So, scenarios 1 and 3 will lead to tax inefficiency and the whole idea of creating this product will be defeated. The wealth manager, who has sold the product, will arrange the buy-back of bond just before the maturity to make the returns tax efficient. For example, IIFL Wealth get this product buy backed in their fund IIFL Cash Opportunities Fund to give exit to their HNI Clients.

Anyone with 10 Crore plus investible surplus can consider this specially when their investment horizon is less than 36 months.

Mutual Funds

I have saved it for last. Mutual funds are one of the most transparent, well-regulated and tax efficient vehicle to invest through. It is suitable for all – institutional investors, HNIs, Family Offices, retail investors, corporate treasuries…everyone.

In Fixed Income, (non-equity oriented mutual funds), taxation is favorable. Investors, with holding period of more than three years, gets indexation benefit as well as lower tax rate (20%).

Two categories which I like the most are:

• Target maturity funds

• Open ended schemes following a roll-down mandate

One fund which I like most, in roll down mandate, is Nippon India Nivesh Lakshya Fund, it is an open-ended fund, which invests only in Government Securities and hold the securities till maturity. When the securities are matured, the scheme will invest again in long dated maturities, thereby deferring the taxation.

This deferment of taxation is an advantage as compared to target maturity funds. Another differentiator is the security selection, there are no PSU Holdings, its 100% Government Securitites.

Currently this fund holds government bonds maturing mostly in 2044 to 2046.

This fund allows investors to lock-in interest rates for 20-24 years. The Yield to Maturity as on 31st August’2022 is ~ 7.53%.

Please be aware that in short term the volatility in this fund will be high due to high interest rate sensitivity. As the time goes by, the interest rate sensitivity will come down, that’s the beauty of roll down maturity. Nippon is very clear about the investment horizon, that’s why the AMC has levied the exit load of 1% for 3 years just to discourage investors from taking any short-term view. I strongly recommend this fund to investors with 7-10 years (or longer) of investment horizon.

In PPF, we can only deposit up to 1.5 Lakhs per annum, this fund will give approximately same returns (and probably more). At the same time, there is no lock-in, liquidity is available at T+1 basis. Rates of small saving schemes are announced on quarterly basis. I believe, once we get through this inflation cycle, rates in India will go further low and investors who can lock-in the rates for long term in this upcycle will applaud their decision.

Nothing in this article should be constructed as an investment advice.