Debt returns going south poses a great challenge for investors

2018 has indeed been a rather sad year for equity related investments. The indices by themselves have given poor returns, the broader markets have under-performed more significantly and select stocks have really tanked in a brutal manner. However, people investing in equity for a long time, such as me, can take this in their stride knowing that a good year in 2019 or after can redress this to some extent. 

There is however, another issue which many of us miss badly. Not only have equity returns plummeted, Debt returns have gone south too. Let us look at some data for the best performing funds in different categories to first understand the factual context :-

  • For long term Debt funds the best one year returns are between 2.6 % and 3.5 %.
  • For same category 3 year returns are between 6.5 % and 7.1 %. Returns for 5 years range between 7.9 % and 9.1 %.
  • For short term Debt funds the best one year returns are between 5.9 % and 6.2 %.
  • For same category 3 year returns are between 7.3 % and 7.6 %. Returns for 5 years range between 8.4 % and 8.7 %.

So what does this mean in real terms to an investor who has parked some of his money in Debt funds as part of his asset allocation? Firstly, while the 5 year returns still look good for the best performing Debt funds, these will now start to get impacted by the poor current performance. Secondly, if you are parking your money for 2-3 years then Long term Debt funds are a really bad idea, you might as well keep your money in FD or Post office. Thirdly, if you are looking at some regular income and had assumed you will get 8 % every year, you really need to rethink your strategy.

How dramatic has been the change over the last 5 years or so? Let me illustrate this by a personal example. As many of you know, I have substantial investments in FMP type of products as I like the relative stability they bring to expected returns. As and when they get redeemed, I reinvest the Principal and use the capital gains for my regular expenses in my current FI state. Now look at the following data :-

  • Recently there was a redemption of an FMP – ICICI Capital protection plan, where I had invested 2 lacs. This was a 5 year plan.
  • Yesterday I received 3.21 lacs for it and the XIRR was 9.93 % over the 5 year period.
  • An exactly similar scheme I had invested in December 2016 now has an XIRR of 5.26 % only.

It will be obvious from the above that the first investment suited my situation perfectly and the second is really not doing so. As I had said earlier, dramatic recovery from this 5.26 % XIRR is unlikely. At best I can hope for is 6 % or so and this will hardly be very worthwhile, given the lock-in period of 3 years plus.

So the question remains as to where should one put his or her money? More specifically for me, where should I put my 2 lacs now? Actually, it is about 3 lacs as I do not really need the capital gains amount for my regular expenditure. 

I will try to address this in the next post.

FMP investments may not pay off now

Followers of my blog will know that I have significant investments in Fixed Maturity Plans of fund houses. These were undoubtedly the best instruments till 2014 where the LTCG indexation was available after 1 year as opposed to 3 years for other debt funds. In that period all capital gains from FMP were akin to tax free income for me

While the Finance minister changed the LTCG time frame to 3 years in the budget of 2014, FMP was still a viable instrument if you were willing to hold it for 3 years. The reasonable returns, coupled with the indexation benefits made it more attractive than many other Debt funds. Personally, I rolled over all my FMP investments to 3 years and that worked quite well for me – I used the capital gains for my regular expenses, mostly discretionary ones, and reinvested the principal amount in FMP or other hybrid funds. Of late I have preferred Hybrid funds rather than pure Debt focused FMP.

So why do I say now that this is no longer something which can pay off? There are two broad trends in this space that forms the basis of my opinion. Firstly, with the lowering of inflation and consequently the interest rates any fresh FMP will be likely to give returns only between 7 % and 7.5 %. Remember that by it’s very nature FMP’s invest in securities at the start of term and hold it till maturity. While this provides good downside protection, it obviously does not work well when the interest rate cycle reverses direction. For example even if the interest rates increase by 100 basis points next year, the 3 year FMP I start now will not get any benefit from the same. 

Secondly, with the inflation rates in the economy having a downward trend, the Cost Inflation Index is rising at a much slower pace than before. As a result the indexation benefits one was used to getting earlier will be significantly lower now. In real terms this means higher capital gains after indexation and therefore a higher tax liability. These two factors combined will mean that your effective post tax returns from FMP will be much lower than it used to be 2 years back.

Let me try to illustrate this with a real life example from my portfolio below:-

  • An ICICI FMP bought in November 2013 and rolled over subsequently has now matured in July 2017.
  • Purchase cost was 1 lac, Redemption was done at 1, 34, 529 Rs and the indexed purchase cost with application of new CII was 1, 19, 809 Rs.
  • Capital gains after indexation is therefore 14, 720 Rs. Tax on it @ 20 % is 2944 Rs.
  • Effective returns over 3.5 years is therefore 31.5 %
  • CAGR over this period will be only 8 %

Now while a post tax return of nearly 8 % is definitely not bad in today’s scenario, remember that this will keep getting worse and will be a lot lower for an FMP you are entering today for the next 3 years.

Now if we agree that FMP is not the preferred instrument of investment right now, the question remains as to where can we invest then? I will recommend Hybrid funds that have some exposure to equity apart from debt. Look at the following options:-

  • Dual Advantage Funds among FMP space
  • Equity Savings Funds
  • Monthly Income Plans
  • Dynamic Funds

All these will come with some risk exposure but 3 years on our markets should be doing better than today anyway.

FMP redemption – a case study in April

As all my regular readers will know, a lot of my debt investment have been historically into FMP instruments. The basic premise of this is simple – it is a safe investment with relatively stable interest rates you can lock into for 3 years or more, the indexation benefits are good and consequently the taxes are reasonably low. If you want to read more about why I invest in it you can go through the FMP related blog posts.

The way I approach FMP redemption proceeds can be summarised as below:-

  • The capital gains are used for my regular expenditure if required. These form a good part of my passive income stream and, more often than not, I use it for some discretionary expenses.
  • I normally reinvest the principal amount in some other debt instrument, it could be FMP again or something else depending on the context of time.

So far in April, 3 of my FMP investments have been redeemed and the overall details are as follows:-

  • The principal amount in these three were 7 lacs.
  • Total capital gains arising out of these redemption is 2.25 lacs. In terms of XIRR it translates to around 9.75 % which is pretty good.
  • At this point in time, I do not really need the capital gains for my expenditure. This is mainly due to my active income through Consultancy which is more than adequate to take care of my regular and discretionary expenses.

Based on the above considerations I have decided to invest 9 lacs out of the redemption amount. In the present interest rate cycle, investing in pure debt products will really not make sense. As such, I am looking at the following distribution:-

  • Dual advantage FMP which invest in equity to a small extent.
  • Close ended equity funds such as Sundaram long term micro cap fund.
  • Equity savings funds.
  • MIPs
  • Funds such as ICICI Balanced Advantage fund or Edelweiss Absolute Return fund.

As some of these funds are dependent on market levels, I will be waiting for the annual results to be out. My feeling is Nifty will get down to below 9000 levels shortly and that will be a good time for me to buy these instruments.


FMP investment – A personal case study

Most readers of my blog will know that I have had a preference for investing in FMP over the past few years. So much so, that about 45 % of my debt portfolio is invested in it. I will not go into the reasons for it in this post, if you are interested search my blog and you will see the basic logic of doing so. In simple terms, I use the capital gains from FMP for my regular expenditure and re-invest the principal in some debt instruments, FMP or not.

For indexation purposes all the schemes I currently hold in the FMP category are of duration 3 years or more. In effect this means about 1/3 of my FMP investment will get redeemed every year. In the last two financial years I had to do some rollover of schemes which were of less than 3 years. That is over now and I am able to see the full impact of my strategy regarding FMP in this FY.

One of my FMP schemes from DSP BR fund house matured in the first week of July. The facts of the investment are as follows:-

  • Investment amount in the FMP was 300000, done in July 2013. Initially it was for 2 years and I had rolled it over for another year, to get indexation benefits.
  • Redemption amount was 3,94,000. The CAGR of the investment was 9.51 % which is quite good, compared to the other debt options available at that time.
  • As per my plan I am going to use the capital gain of 94000 for my regular expenditure and re-invest 3 lacs in some instrument.
  • Based on the other FMP that will mature over this FY, I think I will be earning an overall capital gain of about 4 lacs in this year. This is about 50 % of my annual planned expenditure, not taking children’s expenses and rent into account.

So, one part of my strategy is working quite well as I get decent returns and not have to pay too much taxes on it. In a rising interest rate regime, the easiest thing would be to reinvest the principal amount in another FMP. Unfortunately, with the interest rates having come down significantly in the last 2 years and likely to go lower, this is not a viable strategy. I have looked at the different options in the debt/hybrid space and have come up with these:-

  1. Monthly income plans
  2. Equity Savings funds
  3. Arbitrage funds
  4. Short term Gilt funds
  5. Short term debt funds

With the interest rates being what they are, hybrid funds with a little bit of equity kicker is the order of the day currently. Also for the instruments 1-3, taxation is not going to be an issue after a year. Out of these I ruled out 1 and 2 for this week as the markets being high does not make them an ideal buy right now. I have distributed the 3 lacs equally among the other 3 categories. If in future the markets are down when I am in need to reinvest my principal amount from FMP redemption, I will choose 1 or 2.

In other words I have investments in all the above 5 categories and over a period of time the dependence on FMP will reduce in favor of these. Of course when interest rates stabilize it will again be a good time to buy FMP.

I hope this was useful for the readers and they will be able to use some of these techniques in their passive income generation.

My Debt portfolio – rethinking FMP

Readers who have read my earlier blogs will have a good idea about my 3 portfolio strategy and how I use it for generating passive income as well as growth for the future. A major part of my Debt portfolio is FMP schemes and I have been investing in these for the past few years to build up a decent portfolio.

In essence the FMP strategy was quite simple to start with, especially when the LTCG indexation benefits were available after 1 year. Between 2008 and 2013 the cost inflation index was increasing by more than 9 % or so every year. This meant that you could practically get tax free returns of 8 % or slightly more every year. All you had to do was reinvest the principal amount in another FMP scheme and use the capital gain for whatever purpose you wanted. When I was looking at setting up a passive income stream from 2015, this seemed like an ideal avenue. I reasoned, if I could have about 50 lacs in different FMP schemes and roll them over every year then my capital gains would be about 4 lacs assuming an return rate of 8 %. Along with some other passive income elements, this would go a long way to meeting the 8 lacs of current annual expenses that I have.

However, in the personal finance space any plan is good only in the current context and a change in the environment will necessarily mean you have to change your plans. The first spanner in the works were thrown by Arun Jaitley after BJP came to power. He made all Debt funds, including FMP, eligible for LTCG only after 3 years. This immediately meant that my plan of rolling over the FMP schemes yearly, was a non starter. Fortunately, some of the schemes I had invested in were already 3 years and for the rest a rollover was made possible by all the fund houses. As I was able to direct some of my active income towards my expenditure needs in 2015, the 3 year time frame did not really affect me. From 2016, I roughly have 20 lacs worth of FMP investment maturing every year. This will yield roughly 4.8 lacs in Capital gains as the holding period is at least 3 years for all maturing schemes. So in theory my earlier plan or reinvesting would still work, though with a 3 year duration as opposed to the 1 year duration I had thought of earlier. Note that I prefer FMP as the interest rates are locked in to a significant extent and are not prone to risks as other types of debt MF schemes are. For my debt portfolio, stability and regularity of returns is key.

Though the above strategy looked great, I am now having to rethink it as there is another significant change that has happened in our environment. With the inflation rates coming down, the cost inflation index will obviously increase at a lower rate as compared to before. In the last year the increase has been less than 6 % and going forward I do not expect it to be very different, a lower rate of increase is actually likely. This will mean that even after indexation, there will be some capital gains tax which needs to be paid. This is a double whammy for FMP schemes – the returns will get lower with declining interest rates and the effective taxation will come into play. The returns therefore seen unexciting now.

Now in 2016 I will have about 20 lacs of FMP maturing and I need to reinvest it somewhere. There are a few options that I have thought of. Pure debt funds will suffer from the same issues as FMP and they are likely to have higher credit risk too. Moreover the 3 year locking period with lower indexation benefits, suddenly make these funds rather unattractive. Even though I have never been a fan of mixing equity and debt, as they are very different asset classes, this may be a situation where such a course of action is pragmatic. The following options can be looked at:-

  • A conservative Balanced fund where the risks are contained.
  • An Equity savings fund with both hedged and non-hedged equity in addition to debt.
  • An arbitrage fund with mainly hedged equity.

The good thing about all of these is that LTCG becomes effective post 1 year. The risk is that if the markets do badly the returns from such funds can well be lower than the ones I am getting from my current FMP schemes. However, given the current situation, these seem to be a good idea as the credit risk is limited and potential of returns optimistic if the markets do well in the next 2-3 years.

Of course, once the interest rate cycle reverses the situation will become quite different and a return to FMP type of schemes may well be the order of the day.



How I use FMP to generate passive income

I have got a lot of queries for sharing my strategy of creating a passive income stream to take care of my regular expenses. This helps me in having peace of mind and allows me to take up the kind of work that I am genuinely interested in. I have multiple strategies to take care of the passive income stream as well as backups for some of these. One of them is my investment in tax free bonds which gives me about 1/3 of my annual expenditure need. The other strategy was to invest in FMP s in a way that I generate income out of it. I will explain how I do so in this post.

As many of you know, a Fixed Maturity Plan is really a category of Debt mutual fund where the redemption date is defined. All FMP invest in government papers and other such highly secure instruments which will mature on or just prior to the date of the FMP maturity. Therefore, in essence you can be assured that your returns will only fluctuate within a very narrow range even though the fund houses cannot tell you that due to the SEBI guidelines. What attracted me to FMP in the first place was the fact that the returns were pretty much comparable to an FD and sometimes even better but the FMP had a huge tax advantage. Having paid huge taxes in my years of corporate earning, I was especially keen to see that I can minimize my tax outgo when I was setting up a passive income stream.

Till the budget of July 2014, FMP really was a great product as the LTCG for it was defined at 1 year. Essentially, this meant if you could earn 8-9 % in a year, indexation took care of most of it and your tax liability was practically minimal or even nil. From 2010 through 2014 this was a bonanza as far as I was concerned. I could use the capital gain to fund some discretionary expenses and indulgences, not really pay much taxes on it at all and roll over the principal. To give an example an FMP of 3 lacs for 1 year will have a capital gain of about 24000 Rs which can be used for any purpose and the principal of 3 lacs could be rolled over into another FMP.

The tax treatment of FMP was really an anomaly and it got corrected in the 2014 budget where the LTCG was defined at 3 years. Fortunately, the option of rolling over 1 year FMP to 3 year FMP was given by most fund houses, so in effect the deal was not really a bad one. It did mean that the capital gains I was expecting in 2015 from the 1 year FMP would not happen in the year. This was not an insurmountable issue as I had several backups for the passive income needed.

Let me show you a generic example of how FMP can be configured to generate a passive income stream:-

  • Let us say you have put an amount of 30 lacs in FMP, with 10 lacs maturing every year. This is what I had done in 2013 and 2014 when I wanted to create a passive income stream from 2015.
  • Each year 10 lacs of FMP will be maturing and all of these will be 3 year FMP. You will therefore be getting a total amount of around 12.7 lacs ( assuming 9 % return ). 2.7 lacs out of this is LTCG and after indexation benefits you will not pay much taxes on it. So in effect you have this amount tax free ( nearly ) for your passive income.
  • You invest the 10 lacs principal amount into other 3 year FMP or other debt funds as per your choice.
  • You will continue to get this year after year and the tax incidence is limited, definitely nowhere near FD s.

Having said all this, do FMP s remain as attractive now as it used to be a couple of years back? One issue clearly is that like other Debt funds you need to have these for 3 years now in order to get indexation benefits. That is OK but there are issues in indexation as well as the returns that we need to consider. Let me do another post on this as this one is already quite long now.