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.

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MF investments and LTCG tax – the real impact

With a lot of heat and dust about the LTCG taxation on equities one aspect of it, namely, the real impact of the tax on an investor’s long term return have largely got very little attention. I was made aware of it through an article by Dhirendra Kumar of Value Research Online and largely agree with what he has said. As many of the investors may have missed out on this, let me try and explain it in this post.

Now, we all know that it is possible for equity to grow at a rate of 12-15 % in a long term period of 10 years and more. Of course, the growth in equity is non-linear, meaning you may well grow 30 % in a year like 2017 and even have negative growth as in 2008 and 2011 etc. If we look deeper into the growth of our MF investments we will see there are clearly 2 parts to it – first is the inflation prevalent in the economy and the second is the real return you get on your investment. For example, if your MF investments have grown by 15 % and inflation during this period was 8 % then your real return is 7 %. In general, your real return can exceed 10 % in a good year for the markets and will be in the range of 4-8 % in other years. Again, if the markets turn negative or are mostly sideways in a year then your real returns may well be negative.

With this backdrop, we will take an example to understand the impact of the recently introduced LTCG tax on equities on your MF returns:

  • An investor starts investing through SIP in one of the popular MF schemes from April 1st 2018. Let us say the amount is 20000 and he wants to do it for 15 years.
  • At 12 % annual returns he will get about 1 crore, which he plans to use for his daughter’s higher education.
  • His overall LTCG will be to the tune of 64 lacs and the tax thereon will be 6.4 lacs.
  • Now if we assume that the inflation component is 6 % and the real returns are also 6 % then the real returns are to the tune of 32 lacs.
  • In effect you are paying 6.4 lacs tax on a 32 lac real gain – this comes to 20 % and not 10 % as most of us are given to understand.
  • This situation could have been corrected if indexation was allowed but that has not been done in the case of LTCG on equities.
  • The 1 lac exemption etc has very little meaning for people looking at a large goal as it will be an insignificant part as compared to the goal amount.
  • In simple terms you are being taxed on inflation too, which is grossly unfair !!

In terms of the goal itself, you will need to increase your monthly SIP amount by 1281 Rs so that you are having the required goal amount after taxation.

So what can you do from your end to see that you minimise the taxes at least? Well, for one, you can spread the redeeming over the years of college so that the impact will be shared over 4 years or so. This will not affect the total tax outgo but you will feel better that your tax payment at one time does not appear so horrendous.

I hope the intelligent readers would have understood the real dangers here. Even if your real return is much lower, say 10 % you still pay a lot of tax. For the above example at 10 % returns your LTCG is 47 lacs and you pay tax of 4.7 lacs. As a percentage of real return you are now talking of well over 30 %. If your real returns are even lower if the market tanks in that year, then the tax paid as a percentage will be even higher.

The conclusion is a simple one – by not allowing for indexation the FM has really dealt a body blow to long term investors who have been investing seriously over the last several years and have played a stellar role in the success of our stock markets.

What strategies can you adopt for your investments? I will take this up in another post.

My investment in hybrid funds – why and where?

Readers of my blog will know that in general, I am not fond of mixing asset classes for the purpose of investments. Even in the 3 portfolio strategy that I have, the investments in Debt, MF and stocks are demarcated and carried out separately. I believe strongly in deciding on an asset allocation and sticking to it through different market cycles.

However, after I gave up my regular corporate career by end 2014, I was dependent on some regular passive income to fund my FI state. While I was still earning a decent active income which could potentially take care of all my expenses, I did not want to depend on it. The cash inflow through my active income from Consultancy is used for any discretionary expenses, investment or for some charitable purposes. Most of my Debt investments were in PPF and FMP with a little in short term debt funds. When the FMP schemes matured, I used the capital gains as my passive income and reinvested the principal for 3 years to take advantage of indexation.

With the reduced interest rate cycle being active, investment in pure debt FMP did not seem like a good idea from 2015. The likely returns reduced a lot and I started looking at options for investment. The obvious choice would have been Balanced Funds but that would have skewed my asset allocation as equity oriented Balanced funds invest nearly 65 % of their assets in stocks. This led me to look a little deeper into the hybrid category of funds. While there can be variations to the theme, most of these fund types have 3 types of investments in their portfolios – Debt, equity and arbitraged equity.

The different types of funds will have these 3 investments in different proportions. Some of the common types with their investment weights are as follows:-

  • Dual Advantage FMP which invest in some equity apart from the regular Government papers. The amount of equity will normally be 10-15 %
  • Monthly Income Plans which are similar to Dual Advantage FMP except that they are actively managed and declare dividends more frequently. 
  • Equity Savings Fund which invest equally in Debt, Equity and Arbitraged equity.
  • Debt oriented Balanced funds which have about 30 % Equity and the rest in Debt.
  • Equity oriented Balanced funds which have about 65 % in Equity, rest in Debt.

In the initial years of 2015 and 2016 I did not have too many FMP maturing as I had rolled over most of these for 3 years due to taxation reasons. Most of the redeemed amounts were put in Balanced Funds and Equity Savings Funds. The advantage of these funds is that you can redeem them after a year without having to pay capital gains taxes. In 2017 I had a lot of FMP maturing – I used the principal amounts to make some investments in MIP and the rest in Dual Advantage plans of FMP. Except for using the money from FMP capital gains, I have not used money from any of the other funds listed here, neither have I touched the interest from PPF or POMIS.

What about returns ? Normally they will be within a range and typical values will be :-

  • 12 % – 15 % and more for Balanced Funds.
  • 10 % – 12 % for MIP
  • 11 % – 13 % for Equity Savings Funds
  • 9 % – 11 % for Dual Advantage FMP
  • All of the above are of course market dependent and can go lower if market performs poorly.

After this year, most of my investments will cross 3 years and I can then redeem these in a tax efficient manner. The objective of getting some differential return through hybrid funds is being realised now – my audit of investments for last year established that.