Is Direct Debt the Contemporary Investor’s Sensible Bet?

We are surrounded in a vague global financial scenario today, with UBS acquiring Credit Suisse and Silicon Valley Bank collapsing. An investor is jolted with big names coming close to bankruptcy, making one rethink one’s fundamentals. The regulators and commentors have been asking us not to worry, but the question is whether to believe them or not?

With global markets in an upheaval, on the domestic end, we saw the amendments to the Finance Bill,2023 being announced on Friday. The Finance Minister Nirmala Sitharaman has withdrawn the Long Term Capital Gain advantage which the Debt Mutual Funds were currently enjoying. Debt Mutual funds (funds holding less than 35% equity) were allowed a LTCG tax rate of 20% with an indexation benefit (if held for 36 months or more) or at 10% without Indexation. Post 1st April, 2023, any investments made in Debt Mutual funds would attract taxation as Short Term Capital Gain according to slab rates.

This amendment puts bank FDs at par with the Debt Mutual Funds due to their tax treatment, leading to a blow to the Asset Management Companies by losing one of their key differentiators. Won’t the industry see a shift in the mindset of the investors? This also brings into limelight the possibility of investing into Bonds/NCDs over Debt MFs.

In a volatile market, an investor would ideally prefer fixed income securities for capital preservation, periodic income stream and fixed duration of investment. The investor who desires to have a fixed income return, would ideally expose himself to Fixed Deposits, NCDs/Bonds or Debt MFs.

Categorically stating, we can divide the avenues for investment into 3 groups:

Fixed Deposits: IF one chooses to invest with high rated banks, they will be exposed to very low risk. The returns are usually lesser than those of Bonds or Debt MFs. Fixed Deposits are very popular choice of Indian Households due the limited risk & certain returns. But they don’t have an opportunity for a capital gain. The investor can only avail regular interest incomes, also FD returns seldom match inflation rates. FDs are a safer bet also as the DICGC covers depositors of commercial and cooperative banks upto Rs. 5 lakhs, but we should be wary of incidents like the PMC bank scam, which can leave the depositor vulnerable.

Bonds (direct debt): Bonds are becoming popular & are mostly chosen by investors seeking a higher return than FDs . Bonds are generally backed by security or Sovereign Guarantee. The ratings by institutions like CARE, CRISIL, ICRA, etc., help the investor make an informed decision. Due to fluctuating yields, an investor gets to seize the price difference leading to an opportunity to earn a capital gain. Direct Debt is the only fixed income investment option which will have LTCG benefit if held for more than 36 months. It is taxed at 10% for listed debentures and 20% for unlisted debentures. A low risk-appetite investor has a choice of Secured debentures, G-Sec & AAA rated bonds will be at par for risk exposure with FDs. However, an investor can choose lower rated bonds to enhance his risk-reward ratio.?

Debt MFs: Debt funds are diversified across various securities to assure a stable return. There will be no guaranteed return but an expected range of returns. Saying this, we cannot ignore the fact that the risk depends on the strategy of the Fund Manager. If he chooses to play an aggressive game to achieve higher returns, the risk of the Debt MF will increase. It’s inevitable to think about the Franklin Templeton debacle of April 2020, shaking the core of the Debt MFs industry, as they had to shut down 6 debt funds, due to redemption pressure and lack of liquidity in the secondary market for the underlying instruments.?

With no tax arbitrage, Debt MFs are surely losing their edge. An investor is surely going to seek comfort in the safer haven of Fixed Deposits. But shouldn’t we consider the opportunity, Bonds segment has to offer us?

Direct debt investments will continue to offer LTCG benefit, investors with a horizon of 3 years+ will prefer them over Debt MFs. Currently we are also at a high interest rate in the market, which may peak in the near future. If an investor has a window of 3 years+, he shall see an interest rate correction in the future, leading to capital gains being generated in their bond investments.

With higher returns, more transparency, easy accessibility and guidance from various retail platforms and no management fees, investments in direct Debt should make a gainful impact on the portfolio of the investor.