Lower inflation will cap income from debt investments

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.

About Author

Ramesh Sigamani

Ramesh Sigamani

With over 3 decades of experience in capital market investments, Ramesh Sigamani is a trusted Financial Planner par excellence. He works personally with individuals and corporates to build a strong investment portfolio that stands firm against market volatilities and delivers time & time again.

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