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Debt investing: It's not only about returns

Understand taxation and actual returns before investing in these instruments

Suresh Sadagopan 

It is not surprising that bank fixed deposits (FDs) are investors' favourite instruments. Well-defined tenure, pre-determined rate of return and low-risk make these very simple instruments to understand. But they have weaknesses. Interest rates are moderate and taxable. Since tenures are fixed, premature withdrawals mean penalties. To choose any debt instrument, investors need to consider various factors.

The risk-return game: Any investor would have a returns' expectation and a risk he is comfortable with. As a rule, the higher the risk one is willing to take, greater the returns. For instance, a lower-rated FD would offer more returns as compared to another with the highest rating level. Hence, the investor needs to be clear about the level of risk he is comfortable with before investing. People are searching for low-risk products which offer high returns - that is as elusive as a unicorn!

Liquidity: An important element. Many times, the investment is done by looking at the interest rates alone. But when one's situation changes and money is needed suddenly, some instruments either cannot give the entire amount (Public Provident Fund, company FDs) or impose a penalty or reduce the rate of return (company FDs/bank FDs). Look at the fine print carefully before investing.

Tenure: The purpose should be considered before investing. That will dictate, among other things, tenure of the investment. For instance, if saving for a child's graduation expenses, four years away, invest a lumpsum amount in an FD or any other debt instrument for that period.

Investing in an instrument like an FD or Fixed Maturity Plan insulates a person from interest rate risk for the tenure of the investment. However, at the end of tenure, there is a reinvestment risk. That is, one might end up with a lumpsum amount without having an instrument which will give similar returns. So, it might end up lying idle in the bank and earn a paltry rate of four per cent to six per cent. But if it is invested in a manner that the instrument matures just before the goal, then the reinvestment risk is avoided.

For really long-term goals like retirement, investments like New Pension System, Public Provident Fund and Employee Provident Fund are suitable. These, more or less, lock-in one's investment for a long time. And, the returns can be higher because of the compounding effect over a longer period.

Tax savings: For some, tax benefit is another reason to invest. They may be looking forward to investing under Sec 80C or Sec 80 CCD and others to claim deduction from the taxable income. Other instruments like PPF, tax savings mutual funds, NPS, bank FDs for five years or more also come under one of these sections.

Tax-efficient investing: This is an area where investors stumble. Most tend to look at pre-tax as opposed to post-tax return. For instance, investors look at the interest offered by banks or company FDs and assume this is the real rate of return they are earning.

However for someone in the 30 per cent tax slab, investing in a bank FD giving 9.25 per cent annual returns means the post-tax rate is only 6.38 per cent. Also, many banks and companies, publicise their rates in a misleading manner. They show the returns by dividing the final return after several years, by the number of years. For instance, if an FD is earning 9.25 per cent annually, it is the compounding annual rate whether you invest for one year or five years. However, if one invests in such an FD for five years, the returns would be 55.63 per cent. They would divide this by five and show the returns as 11.13 per cent, whereas the actual annual returns still stand at 9.25 per cent.

For people in the higher income brackets, the need to look at tax treatment of income coming from their investments is extremely important. Some of the income generated may be considered taxable income and others may be treated as capital gains. Depending on these, there can be a significant difference in the returns that one may end up getting. It is important to understand all factors that impact a debt product. One's choice of the instrument should be based on the various factors which can impact them, not just returns alone.

The author is director, Ladder7 Financial Advisors

First Published: Fri, May 01 2015. 22:29 IST