Note the exit barriers on debt instruments

There are penalties and loads, and you may even have to sell at a discount in exchanges while moving money from debt instruments prematurely.

With interest rates on the boil, financial planners are aggressively recommending debt funds, fixed deposits (FDs) and non-convertible debentures (NCDs). For an investor, who seeks the safety of debt, along with good returns, this could perhaps be the best time.

There is a catch. If there is idle cash in the bank, one could easily invest in these instruments. However, if the money has to be shifted from existing investments, there could be a problem.
 

WHAT AN EXIT COSTS
Debt instrument	Exit charge/discount on sale on the bourses
Fixed deposit	50 bps to 100 bps
Fixed Maturity Plans	Typically between 10% to 20% discount
Monthly Income Plans	Up to 100 bps
Ultra Short Term Funds	25 bps to 50 bps
Open ended debt funds	50 bps to 100 bps

For instance, shifting from direct equities would most probably mean booking a loss. So, too, with equity-diversified funds. In the case of debt instruments, a number of open-ended debt mutual funds have already started putting an exit load of 50 to 100 basis points if the investor sells the scheme within the first year. While most ultra short-term funds do not charge exit loads, there are some that impute a charge of 25 to 50 bps if you exit between three and six months.

For instance, SBI MF revised the exit load structure of the SBI Dynamic Bond Fund with effect from last week. It has not only increased the load to one per cent from 0.25 per cent; it also extended the applicability of this load to a year. Earlier, exits beyond 90 days were load-free. The UTI Bond Fund will now charge an exit load of 1.25 per cent for redemptions made within 180 days, against one per cent earlier.

However, if one wishes to shift from an existing debt instrument to a higher-paying one, the catch would be the penalty one has to pay or sell at a discount at the exchanges. One has to take that into account because the rate of return has to be more than these penalties.

Let's look at this through numbers. If a person in the highest income tax bracket breaks a two-year FD that was paying nine per cent in the first couple of months to invest in a fixed maturity plan (FMP), there will be a penalty of 50-100 basis points. Since a slightly over a year FMP is offering 9.25 per cent, the incremental benefit is 25 bps. But, since the taxation - double indexation benefit - gives the investor higher returns of 8.32 per cent, this investment would make sense. After deducting the penalty of, say, 100 bps, he would earn 7.32 per cent returns, higher than the post-tax returns from FDs at 6.25 per cent.

Similarly, if he withdraws prematurely to invest it in a 12 per cent paying NCD, his post-tax return is 8.47 per cent. After the penalty, his returns would fall further to 7.47 per cent, again higher than the post-tax returns of FDs.

If he were to withdraw prematurely from an FMP paying 9.25 per cent to invest in an FD or NCD paying 10 and 12 per cent, respectively, the picture is completely different. Since FMPs have to be listed, investors can only exit it by selling it on the exchanges. And, it would mean exiting at a discount of even 20-30 per cent.

Says Mahendra Jajoo, executive director and chief investment officer (fixed income) at Pramerica Mutual Fund, "Since FMPs are very illiquid instruments, they generally trade at a discount. Some FMPs go days without any activity. The debt market in India is rather shallow, which makes it difficult for investors to sell the units at a premium."

In such a circumstance, even if one wishes to move money from an FMP to another instrument, the lack of liquidity means huge losses. In other words, the return from any other instrument has to be substantially higher, hardly possible for debt instruments, to make up the loss incurred from exiting. Similarly, NCDs can be sold only at the exchanges, making these equally illiquid.