Investing in bonds is more than just looking at the tax implications
The fixed income investing landscape witnessed an overhaul nearly a year ago, especially for those invested in debt funds. The government changed the tax rules to make capital gains booked on units of debt schemes acquired on or after April 1, 2023 taxable at the slab rate. Along with this, debt schemes also lost the indexation benefit that allowed factoring in inflation to arrive at the tax payable, thereby softening the tax impact.
The move brought debt funds at par with fixed deposits and bonds since interest received on these are also taxed at the slab rate. Put simply, the taxation edge that debt schemes enjoyed over other fixed income was taken away.
Prior to April 1, 2023, many investors bought units of debt mutual funds primarily for their tax efficiency. However, with all the investment vehicles available to investors, should tax treatment be the primary concern while looking at fixed income options or should investors look at other factors while investing in debt?
The underlying asset class remains the same
Investors should note that whether its debt schemes of mutual funds, traditional life insurance policies or even bond funds of unit-linked insurance plans (ULIPs), all of them ultimately invest in bonds. So, what matters more is to figure out whether bonds, which is the underlying asset class, are attractive investments at that given point.
To ascertain that one should figure out if the bonds are offering attractive payouts and how the interest rate scenario is going to play out in the near term. After the recent commentary by Jerome Powel, Chair of the US Federal Reserve, market participants have again started factoring in a few rate cuts before the end of 2024, hopes of which were diminishing earlier due to the global factors. There is also a general consensus that the interest rates have peaked and would move downwards once global inflation concerns are taken care of.
Looking for higher real returns
Fixed income investors are always looking for returns that beat inflation thereby leaving some real gains in hand in the process. In technical terms, investors are on the lookout for positive real returns. Real return is computed by deducting the nominal rate of interest from the rate of inflation. In the Indian context, fixed interest investors at present should be a happy lot. While the Reserve Bank of India has estimated the inflation to be around 4.5% for the FY 2024-2025, most fixed income instruments are offering much higher than this. Even bank fixed deposits are offering around 7% rate of interest for specific tenures, with some lenders offering as high as around 9%. With such high returns being offered, this can be an opportune time to lock in the rates by investing in bonds.
Be mindful of asset allocation
Though the stock market has done well in the last couple of years and has rewarded many investors handsomely, one should not lose sight of their asset allocation. Investment decisions should be made on the basis of defined financial goals. Asset allocation and choice of investments should be driven by the financial goals, the time required to achieve the goals and the risk appetite of the investors.
For most investors, bonds are a must for a proper asset allocation-based approach as they not only provide stability to the portfolio but provide steady returns. With the likelihood of volatility in a risky asset class like stocks, especially at a time when valuations have run up a lot, the role of bonds in reducing overall volatility of the portfolio cannot be ignored.
Investors also need to rebalance their portfolios periodically to maintain the desired asset allocation. For example, if the equity component in a portfolio has seen a sharp rise as markets go up, the investor should take some money out of stocks and put them into bonds to maintain the asset allocation.
Government making bond investing more attractive
Over the last few years, the government has taken many steps to deepen the debt markets in India. The regulators in the past have also taken efforts to empower investors with moves such as making it mandatory for the issuer of bonds to keep the bondholders informed about the performance of the company and the corporate actions from time to time. These aspects should enhance the investors’ participation in the bond markets and thereby improve the price discovery.
As mentioned earlier, the present fixed income landscape and the interest rates being offered makes it an opportune time to invest in high yield bonds. Bonds maturing over short to medium term can effectively enhance the portfolio returns. A diversified portfolio of such high-yield bonds, with a weight of around 20 per cent in the fixed income portfolio, can be a game changer for many fixed income investors.
Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.