The Reserve Bank of India's (RBI) move to cut the repo rate by 0.25 percent leaves those banking on fixed deposits in a limbo. Repo rate is the rate at which banks borrow from the central bank was previously unchanged for three times in a row.
The move is surely going to hit the retirees and other investors who rely heavily on the fixed income products such as bank fixed deposits. The bank FD rates are already lying low and in all probability, will come down further.
Currently, the 1-year bank fixed deposit interest rate is around 6.75 percent. The senior citizens, however, get an additional 0.5 percent on bank FD, effectively giving them a return of around 7.25 percent per annum. On longer tenure, most banks are offering still lower interest rates.
Over the last few years, the interest rate has been on the downward swing. While, a low-interest rate regime helps borrowers, both individual and corporate, the investors especially retirees or those investors who rely on fixed income to meet their monthly household expenses may find it tough in the falling interest rate scenario.
Effective returns
Bank FD returns are fully taxable. For someone in the highest income slab, a 7.25 percent return translates into a 5 percent post-tax return! And with inflation hovering around the same figure, the real return is well almost zero! Fixed income products, therefore, are merely capital preserving in nature and not meant for wealth creation.
Should a fixed income investor, therefore, consider debt mutual funds as an alternative investment avenue to meet their monthly household needs? While as a FD investor, the safety of principal and assurance of a fixed return are of prime importance, in a debt fund, there's no explicit assurance of both. So, why and how should one consider debt funds a part of their portfolio?
Debt funds as an option
The returns in a debt fund are inversely proportional to the interest rate movement. When rates fall, the returns i.e. NAV of the fund rises. "In such a situation, it has become imperative for retirees to consider debt mutual funds as an alternative, in order to be able to generate FD beating returns while taking on a relatively low level of risk," says Mayank Bhatnagar, Chief Operating Officer, FinEdge.
In addition to the senior citizen savings scheme, post office monthly income scheme, 8% RBI taxable bonds, the bank fixed deposits are a popular investment option for the retirees as they not only offer high safety of the principal but also provide fixed and assured income and do not have any upper cap of investment.
The retirees rely on these investments largely to meet their monthly household expenses. But, when rates fall, their post-tax return could be inadequate to meet their needs. "Debt mutual funds can certainly help retirees in meeting their household expenses. The ideal approach involves opting for the growth option over the dividend payout option, and starting a monthly SWP (Systematic Withdrawal Plan) from the fund," says Bhatnagar.
The debt funds have dividends as well as a growth option. To meet regular income needs, dividends may appear ideal but its tax structure may prove disadvantageous. "Dividends from debt funds are taxed at the rate of 28.33% at the source, making it a very tax inefficient way to generate income," says Bhatnagar. Hence, choose to go with growth option and then opt for SWP.
Liquid funds, income funds, gilt funds, capital protection schemes are classified as debt-oriented schemes for taxation. Units of such non-equity mutual funds held for more than 36 months qualify as long-term capital gains. On such units, long-term capital gains (LTCG) are taxed at 20% with indexation, while short term capital gains on such funds are taxed as per the slab rate of the individual investor.
In debt there's risk too
"Debt funds are not risk-free as they are exposed to risks such as credit risk, interest rate risk and reinvestment risk, to name a few," says Bhatnagar. In the debt funds, foremost is the interest rate risk. Today, it appears the interest rate is on the down ward slide and hence returns from them can be expected to be in the positive territory. But, if the interest rates in the economy take a u-turn, the returns from debt funds will slide too. The other is the credit risk in debt funds. One default may bring down the overall returns in the debt fund.
Which debt funds to choose and which ones to avoid
There are varied types of debt funds to choose from and picking the wrong one could be damaging to your finances. Retirees need to be extra cautious in selecting the debt funds. "Returns from corporate bond funds or credit opportunities funds can suffer if one of more of their portfolio securities goes through a credit rating downgrade, informs Bhatnagar. Some of them could be highly volatile, both over the medium and long term. Here's what Kunal Bajaj, Founder & CEO, Clearfunds suggests:
"Retirees should look to match the tenure of their investments with the right category of debt fund
* For parking your money for up to 3 months: liquid funds
* For 3-6 months: ultra short term bond funds
* For 6-12 months: short term bond funds
* For 1-3 years: intermediate bond funds
* For > 3 years: corporate credit funds, or dynamic bond funds"
Even though the Gilt funds which are predominantly investing in government securities have zero credit risk, the interest rate risk in them is high. "Investors in government bond funds which have better credit quality should remember that the prices of these funds are subject to higher risk of ups and downs due to changes in interest rates," says Bajaj.
For a retiree, building up a portfolio to meet regular income needs requires careful attention. Safety, liquidity and post-tax return have to be kept in mind. "Bank FD can be between 10%-15% of their portfolio for immediate liquidity requirement and debt mutual fund should be around 75%-80% of their portfolio, says Amitabh Chaturvedi, MD, Essel Finance.
The strategy
In order to manage liquidity and interest rate risk, bank deposit holder makes use of the 'laddering' approach. One may create a different strategy to meet one's monthly household needs through debt funds.
Amar Pandit, Founder & Chief Happiness Officer at HappynessFactory.in explains as below:
* Basic rule one needs to follow is, not to withdraw from debt mutual funds until the holding period of more than 3 years is completed in order to make it tax efficient.
* For the income for the initial 3 years, required funds should be parked in Liquid and arbitrage funds, which are a better option compared to saving account and a systematic withdrawal plan should be setup from it.
*Income for 4th year onwards will come from debt mutual funds through systematic withdrawal plan.
*Post 3 years, withdrawal from debt funds are tax efficient (See table below)
Watch outs
Any premature exit from a bank FD may not come with penalties, although interest is paid for the period it is held. In debt funds, there may be an incidence of exit loads. "Some debt funds will charge you an exit load of about 0.25% - 0.5% and generally applies only to periods less than a year," informs Bajaj.
Conclusion
For a retiree, equity cannot be a no-no. Remember, life expectancy is increasing and someone retiring at age 60 could have another 30 years of non-earning life, unless a post-retirement job is on the mind. Bhatnagar suggests, "Retirees should look beyond debt funds and also allocate 10-20% of their corpus to blue chip equity funds, with a time horizon of 7-10 years, through an STP (Systematic Transfer Plan) route. The long time horizon will help absorb much of the volatility associated with equity fund investments, and also help provide a kicker to the retiree's portfolio returns." To take care of inflation and the extending life expectancy, one may also consider 1-2 consistently performing balanced funds that have a mix of equity and debt.
The funds mentioned below are not a part of the recommendation list.
