Real Life Example of Ignorance
I happened to meet my previous landlord last year, whose house I had stayed in on rent and, 5 years back, left it on being transferred to another location by my previous employer. It was the month of July when he was in the process of filing his income tax return (ITR).
During our conversation, he regretfully informed me that he had to part with about Rs 18,000 as tax on the interest on fixed deposits (FDs); TDS had been deducted on his FDs by the bank where he had deposited his money. For the last few years he had invested quite a large amount in fixed deposits in the bank.
When I asked him if he did not know that his total income from his pension was already taxable and the interest on FD would further increase the taxable income, he showed his satisfaction that at least he stopped purchasing new life insurance policies some years back!
He further informed me about his prior investments; a long journey since he got employed in a state government department, and now retired and 62 years old. Earlier on, life insurance policies used to be his pet investment avenue till he came to know about the things which were not informed to him properly at the time of purchase. He got lesser amount on maturity of a policy than what he had thought he would get.
Debt Component of Your Portfolio
You want to choose your investments. For that you have to consider your financial goals, which may vary from short term goals like purchasing a new vehicle for family-use to long term goals like retirement.
Your investment options can be from different asset classes. Debt, along with equity, normally reserves a place in the investment portfolio of all investors. The purpose is to make the portfolio well-diversified and customized to timely achieve different financial goals.
Common investors are not new to debt investments but, as in the above example, they normally employ plain vanilla fixed deposits (FDs) to form the debt component of their portfolio. Now the FDs alone cannot provide the total benefits which can be achieved from the debt investments. Thus largely there remains a scope for making the debt component a more efficient investment.
Debt Investment Options in Market
There are many debt or fixed income investment options available in market with various risk-return profiles and features:
Simpler Fixed Income Options:
The simpler fixed income avenues include Fixed and Recurring Deposits/Schemes in banks and post offices, Public Provident Fund (PPF) in banks / post offices and Company Deposits.
Money Market Instruments:
Money-market instruments are of a short maturity, generally up to one year. These include Certificates of Deposit (CDs) issued by banks / financial institutions, Commercial Papers (CPs) issued by companies, Central Government Treasury Bills, and Bonds and Debentures of short residual maturity issued by companies.
The debt instruments (maturity higher than those of money-market instruments) include Central Government Securities (G-Secs/Gilts), Bonds and Debentures issued by companies (public and private sector) and some others.
The Case for Debt Mutual Funds
Important parameters for an efficient investment are:
- Higher Safety
- Higher Liquidity
- Higher Returns
- Lower Transaction Costs
- Tax Efficiency of Returns
- Ease of Operation
The above described fixed income investment avenues, as stated earlier, come with various risk-return profiles and offer various useful features. Hence these should be included in the debt component of your investment portfolio for the best results. But except for the simpler debt avenues described above, the others are large ticket size investments. Retail investors are not able to invest in these instruments due to higher minimum investment amount.
So the most suitable vehicle for retail investors remains the mutual funds (MFs), using which they can reap the benefits of various debt instruments. The MFs invest in these instruments; a mutual fund investor, through various categories of MF Schemes, gets indirectly invested in the different debt instruments. Various Schemes offered by mutual funds cater to the different requirements of time horizon and risk-return parameters.
Advantages of Debt Mutual Funds
Following are some important advantages that you enjoy specifically as a debt mutual fund investor:
Even on a small amount invested, you get diversified across different debt instruments as well as over a number of companies/issuers.
Risk to Capital:
In comparison to equity investing, investment in debt mutual funds is lesser exposed to the risk of capital loss due to lesser volatility. Hence the debt component shields your portfolio from the volatility of equity markets, generating regular income at the same time.
Flexibility of Investment Amount:
The amount of investment in mutual funds can be very small. This makes it possible for retail investors to take the benefit of investment in the fixed income instruments (CDs, CPs, Bonds, Debentures, G-Secs, etc.) via debt mutual funds, which otherwise is unfeasible for them.
Flexibility of Operation:
Mutual Funds offer a lot of flexibility whereby the investment can be lump sum or systematic investment (SIP) on a monthly/quarterly basis. The withdrawal can also be made fully, partly or on periodic basis. There is also the flexibility of switching the invested amount from one mutual fund scheme to another.
Regular Income Generation:
The instruments in which debt mutual funds primarily invest pay regular interest income. Thus these funds can pass on a substantial part of their surplus to the investor by distributing dividends periodically.
Investment for Short Term:
If you need to park your money for a short period, you cannot do so by investing in equity stocks or equity MFs. There are categories of debt mutual funds, like liquid funds and other short term funds (with a little higher portfolio maturity than liquid funds), which can be used for this purpose.
General Benefits of Mutual Funds
Some of the general benefits available to investors of all mutual funds, including debt mutual funds, are as below:
The funds collected from the mutual fund investors are invested further by the professional fund management team that analyses the performance and prospects of companies and selects suitable debt investments in line with the objectives of the schemes.
The mutual fund administration and management are subject to stringent regulations set by Association of Mutual Funds in India (AMFI) and also by Securities and Exchange Board of India (SEBI).
Open ended funds can be redeemed at any time thus providing excellent liquidity to investors.
Investments in mutual funds are more tax efficient than direct investments as the investors enjoy tax benefits on the income as well as the capital gains earned by them.
The above was to motivate you to make debt mutual funds a part of your investment portfolio. We will discuss in the coming weeks about the various categories and important features of the Debt Mutual Funds. Keep in touch!
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