Most investors need a mixture of equity, fixed income, and other asset classes depending on their stage in life and overall financial plan. Within fixed income asset class, investors face a wide array of options. They can go for bonds, debt funds, liquid funds, Non Convertible Debentures (NCDs), deposits of NBFCs or bank fixed deposit.
What should I do?
In the pursuit of returns, investors are often tempted by seemingly higher rate of returns offered by some NCDs or deposits offered by NBFCs. When bank fixed deposits are returning 7%, a 9%-9.5% AA rated NCD/ NBFC deposit can look like an attractive option. But is it a smart choice to invest in them?
It’s not really as attractive as it looks
Tax: The first thing that dents the attractive returns image is the fact that interest from NCDs is taxed just like bank fixed deposits. This means that you are looking at a post-tax return of 7%-7.5%.
Concentrated Credit Risk: The other factor is that of concentrating your credit risk. Fixed income investments are meant primarily for short term needs where safety is more important than returns. NCDs being issued by companies means that the fate of your instruments is linked to that of the firm issuing them. For the sake of marginally higher returns, increasing your credit risk exposure is unwise. It’s better to just invest in equity if returns are the driving factor considering the risk return trade-off involved.
Liquidity: If a particular instrument does not have an easy exit provision and not traded on a daily basis, there could be some friction to encashing the NCD, in the event you need money for emergency needs.
Considering this rate of return and the potentially higher credit risk exposure, there is a much smarter option that you, as an investor, can explore.
Instead of NCDs, go for liquid funds
Choosing a liquid fund or a low duration debt fund is far more advantageous as compared to NCDs or fixed deposits.
The first thing is the rate of return which is around 7.2% currently. What matters even more is that you are earning good rate of return at a much lower risk. This is one of the most important investment concerns which explains why fixed income has a place in your investment portfolio in the first place.
The second thing is that unlike NCDs, liquid funds or ultra-short term debt funds are taxed only when you withdraw from these funds and only on the actual withdrawal. If you hold the funds for a period greater than three years, indexation benefits apply. This lowers the tax bill even further. This makes liquid funds and ultra-short term debt funds a far more tax efficient option to earn the same actual rate of return.
Thirdly, liquid funds provide you daily liquidity in the event of any emergency. If you want to withdraw the funds, it would be available in your bank account within 48 hours. Some of the alternatives like NCDs may not be readily sellable.
As we often say, smart investors value logic and in this case it’s simply logical to go for an option that lowers your risk, and saves you tax, while earning the same rate of return an NCD promises.
To sum up
Investing in liquid funds or ultra-short term debt funds is smarter than choosing NCDs. You get similar returns (7%-7.5%) at much lower credit risk. It is also better from a tax angle as you get the benefit of indexation if you stay invested for longer than three years.