Believe in power of compounding? Here’s how Rs 10L investment can yield Rs 70,000 in 1 year

Kotak Mahindra AMC

The first thing that comes to most of our minds when we think of fixed income is Bank Deposits. For many of us, Bank Fixed Deposits (FDs) or Recurring Deposits (RDs) were the first set of investments we made in our lives beyond gold.

Fixed income/securities remains a significant part of our overall investment. Therefore, it is important to understand how one should go about it.

A fixed income instrument would typically be for a fixed tenure. The investor receives a fixed return either at periodic intervals or a lump-sum return along with principle at the end of the tenure.

Any fixed income investment decision should be evaluated against three criteria:

• Return (Post Tax)

Timely payment of principal and interest is important to a debt investor as the objective is to meet safety needs. When we invest in fixed income, the intention is to avoid huge swings and fluctuations in the value of the investment.

We often hear or read about ponzi schemes defrauding investors. Any fixed income investment, by nature, cannot assure abnormally high returns to an investor.

For fixed income investments, an Indian investor has a wide range of options to choose from; ranging from extremely liquid bank accounts and bank deposits to Gilts {Government of India bonds), small savings instruments like National Savings Certificates (NSCs), Kisan Vikas Patra (KVP), compulsory savings instruments like Provident Fund, Public Sector Unit (PSU) Bonds {taxable and tax free), Company Fixed Deposits (FDs), corporate debt and open-ended fixed income Mutual Funds (MFs).

While investing in debt instruments, return of the principal is far more important than return on the principal (interest). An investor must accordingly evaluate such an investment.

Indians can consider investing in Indian government bonds or government guaranteed bonds as the least risky investment option.

Given their low-risk profile, these investments provide lower returns as compared to other debt investments. It might be more rewarding to invest in other options like PSU bonds. NSC, KVP, PPF, etc. Bank deposits of well-managed banks are also considered safe.

The safety of a debt instrument can easily be ascertained from the credit rating of the instrument, as given by reputed rating agencies in India like CRISIL (Credit Rating Information Services of India Limited), ICRA {Investment Information and Credit Rating Agency), CARE (Credit Analysis & Research Limited).

India Ratings (Ind-Ra), etc. Indian rating agencies largely provide a correct assessment of the credit-worthiness (probability of default) of debt instruments. It is therefore advisable to invest the bulk of your fixed income allocation in high-rated instruments having a rating between AA and AAA.

Any decision to invest in unrated bonds or bonds below AA should be evaluated very carefully. Such investments should form a very small percentage of your portfolio.

SEBI regulations require a prominent display of rating in any public mobilisation of debt from retail investors. In the long term, it is more beneficial to forgo an additional one percent return than to take higher credit risk.

The liquidity of an investment, i.e. the ease with which an investment can be sold when the need arises, is important in order to take care of unforeseen circumstances. Liquidity is also associated with the price risk, as selling before an investment matures could potentially result in a capital loss.

Post-tax return, and not pre-tax return, should be considered while comparing different investment opportunities.

The liquidity of an instrument can be ascertained from the in-built liquidity features of the instrument (overdraft facility against bank deposits, loan against debt mutual funds, premature withdrawal facility of bank deposits, put options on debentures, etc.) or listing and trading on the stock exchange.

While listing by itself does not guarantee the ability to trade at any point, it does improve the probability of being able to sell the instrument at a fair price. Most investors invest in fixed income securities and then forget about the investment till it matures.

This is not always the right approach. Interest rates are cyclical in nature and fluctuate in a fairly predictable manner over a long period of time.

Investing in such instruments when the interest rates are high and selling when they are low can help generate additional returns from fixed income securities.

Thus, it is important that you keep the liquidity features of a debt instrument in mind to take advantage of the interest rate cycle and maximize your returns when investing in debt instruments.

The return on investment of a debt instrument should always be considered from a post-tax perspective. One must consider the post-tax return over the entire life cycle of the investment rather than just the tax implications at the point of investment.

A few things to consider while investing in fixed income securities:

(1) Never put all your eggs in one basket. Diversify your portfolio across various instruments so that even if one or two debt instruments may get delayed in crediting interest or default on payment of principal, it does not lead to an unbearable loss for you.

(2) Always go for quality, quality and quality. Avoid investing in poorly rated or unrated investment schemes, however lucrative the returns might seem on paper.

In addition, always remember what J.P. Morgan, the legendary banker, once said many decades ago about his lending style. When asked, "Is not commercial credit based primarily upon money or property?" "No sir," replied Morgan, "The first thing is character." "Before money or property?"

"Before money or anything else. Money cannot buy it ...Because a man I do not trust could not get money from me on all the bonds in Christendom."

Invest the bulk of your portfolio in companies that are highly rated or are backed by the Government of India. This discipline will ensure that the bulk of your portfolio is with reputed blue chip organizations.

(3) "If something is too good to be true, it is unlikely to be true." History does not support scenarios of high interest payment for a long period of time. And it is wise for one to assume that debt instruments offering a very high rate of interest are likely to default sooner or later.

(4) Don't keep your money idle; not even for a single day. No one can give you back even a day's worth of interest lost on idle funds from your hard earned income.

Someone once asked Albert Einstein what amazed him the most. His reply was, "The power of compounding. It never stops; it keeps on accruing." You too must make the power of compounding work in your favour by never keeping your money idle.

Keep only the money you require for emergency purposes in your current or savings account. Invest the rest in liquid funds and other fixed-income funds depending on the investment horizon.

If you were to keep Rs 10,00,000 in your current account, it would yield you no return. However, if you were to invest the same amount in a liquid fund yielding 7% post-tax, at the end of the year you would be richer by Rs 70,000.

For a busy investor, lacking the time and expertise to analyse different debt instruments, an open ended debt fund with its several advantages emerges as a preferred choice for fixed income investment.

Debt instruments provide –

• A simple way to hedge your risks. As a debt fund sources money from numerous investors, it has resources to purchase large number of instruments of varying maturity and yields large numbers of companies thereby minimising the risk.

• High liquidity, as there is a time-bound exit at the prevailing Net Asset value (NAV) by regulation.

• A convenient way of investing, as there is no need to maintain voluminous records and remember various interest/redemption notes.

• Access to the expertise of professional fund managers who work towards optimising the risk return ratio by containing risk and maximising returns.

An investor should diversify between four to five funds with differentstyles of investments to optimize the risk-return ratio. Income earned by an Investor, mutual fund units, by the way of dividend is tax free.

As mutual funds are required to pay dividend distribution tax in debt-oriented schemes. In case of long term capital gains the investor can take advantage of paying tax either at 10% without indexation or 20% with indexation, whichever is lower.*

*As per prevailing income tax rules. Please check with your tax advisor on the latest tax implications.

The investor should evaluate and differentiate between mutual funds not only from the point of view of return, but also on the basis of service standards, disclosure level of information, ethical conduct of business, fair and transparent valuation process and an effective ‘checks and balances' system for internal control and regulation.

Finally, there is no shortcut to generating wealth. It is the end result of a disciplined approach of early and regular saving and wise investing.