Lower inflation will cap income from debt investments

India’s developments have become visible in all areas of economic activity. For a very long time, I remember in my school days, teachers used to say that, inflation in our country is high which posses a big challenge to save money. Slowly this challenge is becoming a myth, we have successfully brought down the inflation rates to below 4% levels.

When Raghuram Rajan talked about this a couple of years back, media brushed aside saying that, it is not going to be easy. Now, as we have reached the goal and beyond, we are looking at a newer challenge. When inflation is low and bank rates are high, real return in the economy is also high. This brings the challenge of having to pay higher taxes on income earned from debt investments which qualify for indexation benefits as well as assets like Real Estate.

In 2014, the debt returns were at 8.7% and tax payable was NIL after indexation. In 2017, the returns is almost the same, where the taxable portion of the income has moved up to ₹15742. Which means more than 50% of the returns will be taxed at 20%, thereby bringing down the net returns by more than 10%.

It is interesting to note how new challenges are coming up in life. If inflation stays low and the bank rate does not come down, taxes on debt fund returns will go up making the net gains reasonably lower. Investors in debt funds will have to re-think their investments.

They will also look to Equity funds which is already getting over crowded. Presently running at about 6 lakh crores and with expectations that there is going to be big inflows due to poor FD returns. Fund managers will now have a bigger challenge on stock selection and allocation of funds.

As it is MF’s are holding cash to the maximum permissible limits, presently a scheme can hold 10% cash. When holding cash in anticipation of a correction, if the market keeps moving higher, all these funds or schemes will have under performance against the broad markets. To avoid investors wrath, fund managers will be forced to invest into stocks that are fundamentally poor, thereby attracting very high risk on the investments.

If markets change course, the retail money that has flocked the Indian Mutual Fund industry will begin to move out, again giving the next challenge of meeting redemption pressures.

As the returns from debt funds are going to become lower due to taxes, what can be the next best alternative. Arbitrage funds will be the next place where we will see high inflows. Arbitrage funds are giving returns that are about equal to the prevailing bank rates for Fixed maturities, the biggest advantage they have is the tax free status or Equity taxation status.

Whereas, Arbitrage cannot absorb big flows as the edge to get returns will move away with huge capital chasing the same instruments in the market, which will bring down returns. As every other door to big returns will get locked as an automatic process, investors will be facing a situation of having surplus liquidity and not knowing what to do with it.

Bank rates coming down or inflation moving up is a requirement to keep things as they are, even this condition will require that, the fund flows into the mutual fund market requires a slowdown. All of a sudden the whole country put all their savings into one asset class will for sure ensure that the asset collapses on its own weight. Beyond our inflows, foreign money is also chasing Indian markets big time. FPI limit of 51b$ has got exhausted as I write this article and RBI is thinking to open another 2b$ for FPI’s.

One more change that could come is the returns on debt funds will begin to decline, which is inevitable & get self adjusted.

Investors beware, quality of your investment needs to looked at on highest priority. Just going to a website and selecting the top ranked fund will no more give the best returns. People need to take help of advisers while doing their investments. soon, we will have analysts who will research and find good Mutual Fund Schemes for investments.

Arbitrage funds are more attractive.

bankslockerRBI reduced interest rates, banks were forced to follow, and now, arbitrage funds have become more attractive for various reasons. At this period, there are other tax free bond issues which have hit the markets, another attractive investment competing against the bank deposits. And due to this banks have lost more than 41000 crores of deposits.

Now, this opens up some concerns. Banks have suddenly hit a vacuum. Today bank rates hover around 8% and all the income from bank FD is taxable at the hands of the investor, which brings down the real returns to a little above 5.50% after taxes for a person who is in the highest tax slab. Compare this with about 7.50-7.60% tax free returns from bond issues and about 7.41-7.50% returns from the arbitrage funds. Tax free bonds are locked in and are very much illiquid when someone wants to sell their holdings, whereas Arbitrage funds are tax free after 365 days and carry zero risk. So the choice of the investment community has changed for good to Arbitrage Funds.

The banks on the other hand are put to some more new challenges due to the interest rate change. Banks normally used to have about 4% spread between the deposit rate and disbursal rate. That is, they borrow at 8% and lend at 12%. Making a cool 50% gain for themselves, for an effort which most of us know about the quality of assets the banks hold. Banking sector was enjoying a grand lifestyle by doing nothing. Now, things have changed, they cannot continue to be lethargic, there is a need for value addition, be more accountable and face the competition.

Corporate bonds give about 9-11%, so when corporates want funding for their businesses, they will not go to the banks as they get funds at a cheaper rate through direct bond issues. For some time now banks had large funds and were finding it difficult to find borrowers to lend their funds and earn, now, very soon fund inflows will dry up and help them do away with the difficulty to find borrowers for their funds. To that extent, they are free of work now. And, who will now want funds from the banks? Small business people, where credibility is a far bigger concern and with the way our banks do due diligence, more defaults are guaranteed.

IMG_2672Arbitrage funds are the best choice; it is liquid and has the tax free status after 365 days from investment. Far less risky, when compared to bank deposits. And how is this now? Off late we have had very big defaults n bank lending, cases like Deccan Chronicle, Kingfisher Air were examples. Banks have lost big time, no doubt government will pay back depositors money, while how long can the government support mistakes made by the banks. Soon, there will be a norm that they have to defend themselves and with that banks have two choices, either perform and deliver or close down. This may take time to come through, until then, invest in a place where you earn more and also enjoy the pain the banking system will go through in the coming years.