How to deal with debt carefully

To tame inflation, the Reserve Bank of India (RBI) raised two of its key policy rates - repo and reverse repo - twice last month. Repo is the rate at which it lends short-term funds to banks. If this rate rises, the cost of RBI funds for banks goes up.

Current repo rate, post the RBI hikes, is 5.75 per cent. Reverse repo is the rate at which RBI borrows funds from banks. An increase can reduce liquidity from the system, as banks find it lucrative to get high risk-free returns. The current reverse repo rate, post the hikes, is 4.5 per cent.

The RBI left the third key rate, CRR (cash reserve ratio), untouched; liquidity conditions were benign. These moves have indicated we are in an increasing interest rate environment and the central bank will not hesitate to be aggressive if inflation continues to be a problem. Inflation numbers seem to be cooling but there will be some uptick in policy rates over the next few months.

At the same time, fixed deposit rates are marginally up. One-year fixed deposit (FD) rates are still low, at around 6.5-7 per cent and have not gone up much. At the same time, in a rising interest rate scenario, long-term debt funds also tend to underperform and can deliver negative returns, as interest rates and bond prices are inversely co-related.

So, what should your debt fund strategy be? First, let us understand the various options -- FDs, CDs (corporate deposits) and NCDs (non- convertible debentures), FMPs (fixed maturity plans) and debt funds (liquid, short-term and long-term).

FDs/CDs/NCDs

Interest rates on bank FDs are still low, at 6-7.1 per cent for a one-year FD and 7.25-7.75 per cent for a five-year one. Interest income on an FD is fully taxable, on the relevant tax slab of the individual; post-tax returns can be extremely low if you are in the higher brackets.

Hence, it does not make sense to lock-in your funds at a lower rate for a longer period. Even for people in the lowest tax bracket, locking in for five years at this time does not make sense and you would do well to look at a 90-day FD.

A person in the higher tax bracket can opt for a floating rate fund or a liquid fund, where one can still earn a four per cent post-tax return. Also, investing in a quarterly FMP at 6.3 per cent can yield a post-tax of over five per cent.

CDs are fixed deposits offered by companies. There are many companies offering a fixed interest from 7.5-15 per cent. However, as the interest rate goes up, the credit risk in that investment also goes up. It is always important to prefer safety over returns from CDs and go for established and well-managed companies. One can comfortably skip the ones offering in excess of 10 per cent annually.

NCDs could also be a good option. An NCD is a debt instrument with a fixed tenure, issued by companies to raise money for business purposes. Unlike convertible debentures, NCDs can't be converted into shares of the issuing company at a future date.

The first one to raise money in recent times was by Tata Capital in February 2009. Fearing tepid response to the NCD issue, this non-banking financial company (NBFC) had planned to raise Rs 500 crore, with a green-shoe (over-allotment) option of an additional Rs 1,000 crore.

However, the company as well as bankers were in for a huge surprise, having got applications of more than Rs 2,500 crore. This prompted many companies to come out with their offerings, the second one being Shriram Transport Finance  in July 2009 and then L&T Finance.

Since NCDs are listed on the stock exchange and offered in a dematerialised form, they are not subject to tax deduction at source (TDS), unlike most FDs and CDs. But, NCDs allotted to non-resident Indians are subject to TDS.

Interest income from NCDs will be subject to your normal rate of taxation. NCDs can also be sold on the exchanges before maturity at a premium, incurring capital gains tax (if sold after a year, the long-term capital gains is applicable) ,which is lower than income tax for someone in the highest tax bracket.

Also, NCDs issued by NBFCs are completely secured by assets of the company. CDs on the other hand, are unsecured and bank FDs are secure only upto Rs 1 lakh. And, despite the secured assets and high credit rating, their NCDs are not fully safe and    there is a risk of default that exists.

Interest rates on CDs and NCDs are almost similar. But, the safety element and the potential to earn higher returns through capital appreciation makes NCDs a better option. Even when compared to bank FDs, NCDs are a better alternative. Their post tax returns are substantially higher, with no TDS but at an incrementally higher risk. However, there are hardly any NCDs available for investments today.

FMPs and Debt Funds

FMPs are essentially close-ended income schemes with a fixed maturity date, running for a fixed period.This could range from 15 days to two years or more. When the period comes to an end, the scheme matures, and your money is returned.

FMPs typically invest in bank CDs, corporate bonds,money market instruments and so on. The tenure of these instruments depends on the tenure of the scheme. That is, if a FMP is a 13-month one, it will typically have bonds maturing in 13 months. Hence, an FMP will carry almost no interest rate risk, which means the value of your investment will not go down if interest rates on corporate bonds move up.

In the current scenario, short term FMPs of three to 12 months are yielding 6.3-7.75 per cent yearly. A quarterly FMP is an excellent choice for someone looking to park funds for three months and a far better option than an FD. FMPs are exposed to a much higher credit risk as compared to bank FDs.

Since, the payment on maturity in an FMP depends on the underlying investments. Hence, it is important that due diligence of the scheme be done before investing in it. Make sure the corporate bonds that are a part of the scheme are rated AAA or at least AA. Avoid FMPs that give you a slightly higher yield but compromise on the quality of the portfolio.

Avoid long-term debt funds for the next couple of months and track the direction of interest rates till October. Once interest rates stabilise, you could  again look at it but for now, you will do well to stay away from long term income funds. However, short-term income funds could be a good option for six months.

The writer is director, My Financial Advisor.