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Dharm Sanskriti Sangam [DSS] 3/64, 2nd Floor, Rajender Nagar New Delhi Vs. The C.I.T [Exemption] New Delhi
January, 02nd 2020

Investors appear to be caught in a situation where post-tax returns in 'safe' investments barely meet inflation, or fall short. To juice up returns, investors need to take either duration risk or credit risk.

Fixed income investors are yet to recover from the aftermath of the ILFS crisis, with some investors incurring losses either in direct investments or through mutual funds in ILFS, DHFLNSE 0.30 %, and other defaulting companies.

The outlook next year for these investors is a mixed bag, depending on the tax bracket and risk profile of the investor.

The middle-class investor
Investors in lower tax brackets are spoilt for choice. Small finance banks offer interest rates between 8% and 9%. While it is difficult to make a prognosis on their long-term health and solvency, bank deposits are insured up to Rs 1 lakh by DICGC, which is wholly owned by RBI. For investors who don’t wish to rely on such insurance, Government of India taxable bonds offer 7.75% for a tenor of 7 years. Post Office deposits offer 7.7% for a 5-year tenor. In today’s low interest environment and inflation at 5.5%, these risk-free rates are indeed attractive.

The not so middle-class investor
For investors in the 30% tax bracket, the going is indeed tough. Risk-free investments, like overnight schemes of mutual funds, offer returns of about 4.9%. Banking and PSU debt funds yield around 6.5-7.0%. Though such debt mutual fund investments are tax-efficient, they are not tax-free.

Public-sector tax-free bonds have poor liquidity for both purchase and sale. The yields, depending on daily vagaries of the market, can vary between 5.0% and 5.5%. Brokerage can further dilute the return.

Investors appear to be caught in a situation where post-tax returns in “safe” investments barely meet inflation, or fall short. To juice up returns, investors need to take either duration risk or credit risk.

Duration risk
Higher the duration of a bond, the more susceptible it is to interest rate movements. Investors in debt funds with medium/long duration have reaped a windfall over the last one year, with a significant fall in interest rates. Bond prices and yields/interest rates move in opposite directions.

Is this the time to take duration risk - that is, invest in debt mutual funds/bonds with a longer tenor, hoping to benefit from a further fall in interest rates? Markets are notoriously difficult to predict. The so-called experts who manage “dynamic” bond funds which are a play on duration, have more often been caught on the wrong side. With interest rates having fallen so much already, and the recent “operation twist” by RBI further bringing down rates, it would indeed be a courageous call to venture into the duration territory.

Credit risk
The time to buy is when there is blood in the streets (or in other words, when the prices are beaten down) is an old saying attributed to Baron Rothschild. Today’s fixed income scenario reflects a deep aversion to risk, and wide spreads between “safe” investments and “credit risk” funds.

Credit Risk funds are an offering in the debt mutual fund category that invest in lower-rated securities. Old hands in the industry consider that this is the right time to invest in such funds, given their attractive returns, in the range of 9 to 10% and the expectation that “all the skeletons have come out of the cupboard”. This would be akin to contrarian investing in the equity segment.

The NBFC crisis has left many credit risk funds bleeding. There are yet others who do not have any securities in the default category, but there is no assurance these will not default in future. Clearly credit risk funds are not for the faint-hearted; many of the names in their portfolio will make conservative investors shudder.

What can investors do?
Fixed income investors in the higher tax brackets can spread their portfolio across the credit spectrum, from the least risky overnight funds yielding about 4.9%, to Banking and PSU debt funds at 6.5-7.0%, and all the way up to Credit Risk funds at about 9-10% yield.

Depending on the risk appetite of the investor, allocation to credit risk funds can be 0-5% of the total fixed income portfolio. Investors need to be cognizant of the prospect of losses in credit risk funds, as the name of the schemes imply.

Arbitrage funds, potential tax-free play up to Rs 1 lakh
Arbitrage funds offer relative safety while being highly tax efficient. They carry the same tax treatment as equity-oriented funds. Returns have been in the range of about 6% and they serve as quasi fixed income investments.
Long term capital gains in equity investments up to Rs 1 lakh is tax free.

This provides an interesting play. An investor who either does not invest in stocks, or does not intend to book capital gains, can invest a maximum of about Rs 15 lakh before 31st March, 2020 in arbitrage funds, and redeem the investment before 31st March, 2021 after holding for one year, booking tax-free returns of about Rs 1 lakh. This strategy can be repeated year after year, unless the tax laws change!

What is the risk in arbitrage funds? Until now they have turned out to be safe, with fixed income like returns. But mutual fund investments are, in general, subject to market risk. The caveat holds true here as well.

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