BackWhich debt investment should you go for against adverse equity market?
When the equity market loses its lustre, debt investments have historically been among the healthiest.
PremiumWhen the equity market loses its lustre, debt investments have historically been among the healthiest. But both equity and debt products have a long history of being used to diversify portfolios. In contrast to the turbulent stock market, which involves high risk and uncertain returns, debt instruments offer moderate returns with reduced risk while also safeguarding your portfolio from negative market responses. Debt instruments like bank deposits have become progressively popular as a result of the exorbitant interest rates brought on by the RBI's decision to raise the repo rate in an effort to control inflation. In an interview with Vineet Agrawal, co-founder of Jiraaf, a brief summary of several debt products and their risk-to-reward relationships has been covered for investors to consider in the midst of the erratic stock market.
Vineet Agrawal said “There are several popular debt products with nuanced variations that are available to investors. And for retail investors, it could be quite daunting to understand each product and its implications from a risk, return or taxation perspective. So, in this article, we will focus on some of the common and important kinds of debt products that you can invest in."
Fixed Deposits
Our parents’ and grandparents’ favourites - Fixed Deposits are the most chosen products for Indians. As per a 2019 survey by SEBI, 95% of Indian families prefer investing in Fixed Deposits! A major reason is that they’re simple products to invest in - You deposit money with a bank, and they give you a fixed interest every year. Another reason is also that they’re relatively safe products - Fixed Deposits up to Rs. 5 lakhs are insured by banks, so even in case of default, the investor can get an amount up to Rs. 5 lakhs.
However, FDs deliver very low returns for investors. Not only do they give low interest (~5% for 1 year investment), but they are also taxed at the tax slab of the investor. This means that for investors who solely depend on this instrument, a Fixed Deposit could be a bad proposition with very low pre- and post-tax returns.
Bonds and NCDs
When a corporation wants to raise money, it can issue Debentures. This debenture is nothing but a promise to pay an interest (known as coupon) to the investor and return a sum of money (known as face value of the debenture) after a certain time period (known as maturity period). So, when you invest in a debenture, you’re essentially giving a loan to the entity and getting interest (coupon) for it. The repayments of interest and principal could be monthly, quarterly or bullet payment at end of the period.
Now, debentures can be convertible or non-convertible. A convertible debenture is one which can be converted to equity stock of the company after a defined period. A non-convertible debenture (or NCD), as the name suggests, cannot be converted to company stock.
A more commonly issued product is a Bond. A bond is a type of debenture which is secured, i.e., the entity issuing the bond has put up some collateral against it. So, in case the issuer of a bond is unable to repay its investors, the collateral provides the support to recover all or some of the invested money.
Secured debentures naturally carry lower yields & lower risk compared to an unsecured product.
Now here’s an interesting concept with regards to bonds - Senior and Subordinate bonds. As the name suggests, a senior bond ranks higher when it comes to liquidation. So, if a company is winding down, investors who hold senior bonds will get paid before investors who hold subordinate bonds. So, if you’re risk-averse, senior bonds could be better than subordinate bonds.
While investing in bonds, external credit rating could also help in choosing the bonds with higher rated bond typically carry lower yield and lower risk compared to lower rated bond associated with higher risk and higher yield. Rated bonds are ones that are given a credit rating (AAA, A, BB, C, D etc.) by rating agencies. Bonds issued by smaller companies or start-ups are generally Unrated bonds given life cycle stage and maturity of the company.
Returns from bonds or other types of debentures come in two parts: The interest (coupon) payments and the appreciation in the price of the bond/NCD.
Since the returns for bonds/NCDs are in two parts, the taxation is also in two parts:
1. Tax on price appreciation: Prices of bonds that are traded keep changing. So, if you’ve sold it at a higher price than what you had purchased it for, you would be liable to pay capital gains tax as below:
Long Term Capital Gains: Taxed at 10%
Short Term capital Gains: Taxed as per tax slab of the investor
2. Tax on interest (coupon): The interest income is taxed as per the investor’s tax slab.
Treasury Bills
Treasury bills (commonly known as T-bills) are similar to bonds but are strictly issued by the government and are short-term investment products. At present, T-bills are issued for 3 different time periods:
1. 91 days
2. 182 days
3. 364 days
Treasury bills are “Zero-coupon" products. This means that there is no interest that the government pays to investors.
“So how do investors earn?" you ask?
Well, T-bills are typically issued at a discounted rate. This means that, for example, a T-bill for Rs. 100 may be issued at Rs. 95. On maturity though, the investor gets the full Rs. 100 back. The difference between the price paid by the investor and the price of the T-bill is the return that the investor makes.
One drawback of T-bills is that the returns generated from them is relatively lower compared to other products. However, the upside is that since they are issued by the government, they are completely safe given stable governments typically don’t default on payments. In fact, T-bills are safer than Fixed Deposits too!
Since T-bills are issued only for short durations, the returns are classified as Short-Term Capital Gains and are taxed as per the tax slab of the investor.
Commercial Paper
A Commercial Paper is a short-term investment option like a few weeks to one year issued by corporations that need to raise money for the near term. It is like T-bills in that it is issued at a discount and the investor gets paid the full amount on maturity, with no interest during the period.
The difference between Commercial Papers and Treasury bills though is the fact that commercial papers are issued by corporations while T-bills are issued by the government. And since T-bills are safer, commercial papers offer better returns to investors compared to their government-issued counterparts.
The returns from Commercial Papers are classified per Short Term Capital Gains and taxed as per the tax slab of the investor.
Alternate Assets
Alternate assets are investment products that fall beyond the traditional investment classes like stocks, bonds, mutual funds etc., and range from products like venture debt, asset leasing, invoice discounting, P2P lending to products like art, antiques, wine, coins, etc.
Let’s look at few important alternate asset classes:
1. Venture debt: Just like mid and large sized corporates raise money by way of corporate debt, small start-ups or MSMEs can also raise money by way of corporate/venture debt.
Venture debt is essentially corporate debt given to borrowers with negative cash flows given the life stage of the company. These instruments are typically secured in nature backed by some collateral such as receivables.
Investors in venture debt should typically look at 12 to 24 months as the time horizon, with monthly or quarterly repayments. Given the fact that it’s riskier compared to corporate debt, the returns are also higher, in the range of 15 to 20%.
The entire deal is structured in the form of secured non-convertible debentures and returns are also taxed accordingly.
2. Asset leasing: An interesting new product category, Asset-backed leasing is where investors invest in an asset which is then leased (rented out) to a corporation (known as the lessee). The lessee then pays the lessor (investors) payments for a time duration, as mutually agreed.
This becomes a win-win proposition for all parties involved, because the lessor earns returns from the rent, and the lessee gets to use the asset without having a high upfront capital expenditure. The investment is secured in the form of the underlying asset.
Asset leasing deals can be structured in multiple ways. One of the ways is to create a separate entity (known as Special Purpose Vehicle or SPV) that is specifically for investing in the assets. The SPV then issues NCDs to the investors and returns are passed on as interest along with principal to the investors, taxed as per tax slabs.
A major advantage of asset leasing is that since the specific assets belong to the SPV (and therefore the investors), in case there is a default, there is a way to recover the principal.
3. P2P Lending: Short for Peer-to-peer, P2P Lending is an innovative investment option where investors can lend money to borrowers via an intermediary platform (a registered P2P NBFC). The P2P platform connects investors and borrowers with each other, helping borrowers get credit and investors in getting a good return on their investment.
While lending to another individual sounds risky, most platforms actually connect multiple investors with multiple borrowers, thereby diversifying the investors’ money across multiple borrowers, lowering the effective risk. However, it’s prudent for investors to research well on the platform, so that their capital is protected well.
Returns from P2P investments are taxed as per the tax slab of the investor, irrespective of the investment horizon.
4. Invoice Discounting: Today, in the B2B space, vendors sell products to corporations with a credit period (typically between 30 and 90 days). This credit period causes a crunch in the working capital for the vendors, so they approach lenders to discount invoices and support them with liquidity. Lenders provide the support but for a defined fee margin. This becomes a win-win situation for all parties because the vendor gets his payment upfront, the client gets a good credit period, and the lender earns a profit from the transaction as well.
Until recently, only banks, financial institutions and HNIs could participate in such transactions. However, now with platforms like Jiraaf, individual retail investors can also participate in these investments. The investors are repaid with interest when the client pays the money at the end of the fixed tenure which typically is 30-90 days. All of this happens via an escrow account and a tech-enabled platform.
With an Indian market size of $100+ billion, Invoice Discounting offers two major benefits:
a) Great returns (up to 14% per annum) compared to other debt products
b) Very short investment duration (30 – 90 days)
The returns of invoice discounting are taxed as per the tax slab of the investor.
Invoice discounting is an unsecured product and therefore carries higher risk compared to corporate debt or asset leasing. Steps are generally taken to reduce risk such as collecting a personal guarantee or undated cheques of promotors who have large stakes in the company.
In today’s dynamic world, investors have a lot of great fixed income debt products to choose from whether it is traditional products or new age products with varied tenures, risk, and returns. Participating and diversifying across these products is a smart way to enjoy great returns on your investments.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.
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