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Alter your fixed income portfolio
October, 14th 2008

As stock markets world-over witnessed declines, Indian investors while focusing on their equity portfolio should also take a re-look at their fixed income investments and restructure it according to the changes.

The income tax rate slabs for the current financial year have been revised thoroughly for individuals. The marginal rate of 30% of income is applicable only for individuals with income above Rs 5 lakh, while the basic exemption limit has been raised substantially upwards for male, female and senior citizen assesses.

If this years income was the same as the last financial year, then the tax payable will be substantially lower-mainly because the rate of tax at lower levels of income has been reduced drastically. This means some low-yielding fixed income investment options like Public Provident Fund have lost their sheen.

Secondly, the interest rates on options like bank fixed deposits, fixed maturity plans (FMPs) of mutual funds, corporate fixed deposits among others have gone up by more than 2-3% per annum. But the interest rate on schemes like PPF, National Savings Certificates, Kisan Vikas Patra, Post Office Monthly Income Scheme as well as taxable government bonds and Senior Citizen Savings Scheme, has remained static at 8-9%.

Thirdly, inflation, which has risen lately, has started showing signs of tapering off. It may come down over the next few months, which will mean that the interest rates too will start falling. If interest rates fall, it makes sense to commit to fixed income schemes offering higher rates of interest for a longer term.

Premature exit options and withdrawals before maturity are not available in National Savings Schemes and 8% taxable government of India (GOI) bonds. In respect of all other fixed income options, an investor can withdraw or close prematurely the lower yielding investments and invest at current high rates.

We should find out whether it would be beneficial to withdraw from these options and invest in higher yielding options available. The important factor that would influence this decision is the rate of taxation on ones income. We will bifurcate the investors as those who are required to pay tax at the rate of 10% or lower and others at the rate of 20% or more.

Investors who will pay tax at 10% or less

Withdraw the maximum amount from your PPF account and invest in bank FDs and FMPs of longer maturities of two years or more. If you can close the account and withdraw the entire amount, then its recommended.

Before maturity, withdraw your investments from the Senior Citizen Savings Scheme, even if you need to pay a penalty of 1%, and invest the amount in bank FDs offering 10% or more. Tax deduction at source (TDS) on a Senior Citizen Scheme, besides the interest rate of just 9% per annum, is a big irritant for senior people.

Hence, avoid this hassle and invest in different branches of banks. If you ensure that the interest on your FDs with a bank does not exceed Rs 10,000 in a financial year per branch, then TDS on interest can be avoided.

Consider premature renewal of your old bank FDs earning a lower rate of interest . Banks consider this without any penalty and roll over your FDs with them at the current interest rate. Long-term deposits of say three years or more are preferable.

Investors who will pay tax at 20% or more

FMPs are the best option for this category of investors. With draw your money from FDs postal schemes among others before maturity and invest in FMPs. The expected yields are even higher than the interest rates on FDs. The tax adjusted yields on FMPs of more than one year is much higher compared to FDs.

The difference between the amount received and the amount invested is considered as long-term capital gains and it is taxed at a rate of 10% without indexation of cost of acquisition or 20% with indexation benefit-under the growth option.

As inflation is ruling high, the application of double indexation benefit to a 19-month FMP which will mature after March 31, 2010, will mean a taxfree income at the rate of more than 10% per annum. Long-term FMPs should be preferred to short-term ones as the interest rates are likely to go down after a few months.

The growth option would be a better one compared to the dividend pay-out option as the fund will be required to pay a Dividend Distribution Tax which is currently 12.5% plus a surcharge and education cess among others (effectively 14.1625%). For investors parking funds in monthly and quarterly interval FMPs, the dividend pay- out option will be better.

FMPs do not guarantee a fixed rate of return and there is a risk of getting lower yields compared to indicated yields. Take a close look where the fund will be investing and rating of the papers-AAA or P1. By avoiding construction company (realty) papers, the risk will be lower. For this category of investors, the Public Provident Fund, despite a lower rate of interest, continues to be a safe bet.

Hence, the account should be continued and efforts should be made to invest the maximum permissible amount of Rs 70,000 as early as possible in the financial year. Thus, restructuring ones fixed income portfolio has become all the more important as equity returns over the last one year have turned negative and are not showing signs of picking up in the immediate future.

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