You cannot build a portfolio purely with equities. There is an element of security and regular income that you need to fall back upon. Whether you decide to reinvest the regular flows or not is a different matter altogether. The crux of the matter is that you need to include a component in your portfolio that offers you stability and regular income. Here are a few popular ways that you can opt for to earn regular income with security of your principal..
Bank Fixed Deposits
These are the most common and popular products in India that provide safety of principal with regular income. However, FD rates have come down sharply with the fall in interest rates. Banks hardly pay around 6.5% return on FDs which just about covers the rate of inflation. These FDs are also inefficient in tax terms. That is because, bank FDs are taxed at your peak rate of tax, which is normally 30%. That means even an FD paying 7% rate of interest will actually pay only 4.9% in post tax terms. Additionally, bank FDs are required to deduct tax at source (TDS) if the annual interest payout exceeds Rs.10,000. This becomes a major hassle for retirees who keep their monies in FDs but end up going through a lot of hassle in getting the refund of this tax paid.
Company Fixed Deposits
Company deposits have the advantage that their yields are still higher than bank FDs. You also get a greater choice among company FDs. For example a FD issued by a company having AAA rating will be around 100 bps higher than the bank FD rate. But as you go down the rating curve, you can even get FDs by quality corporates that pay up to 3-4% spread over the bank FDs. Of course you need to be selective about the quality of companies but you do have the flexibility to enhance yields. However, there are two challenges. Firstly, there is no assurance of safety in case of corporate FDs except the reputation of the issuer. Secondly, like bank FDs, these corporate FDs are also inefficient in tax terms.
Debt Mutual Funds
Debt Funds are fast emerging as a very smart and meaningful alternative to bank FDs. Firstly, the average yield on debt funds can be around 4-5 bps higher than the bank FDs. Secondly, if you opt for debt funds that predominantly invest in government securities then you are almost at zero default risk as G-Secs are full secured. Thirdly, when you hold debt funds you benefit when interest rates fall as it leads to appreciation in the bond portfolios held by the fund. It increases the capital gains earned by the fund and enhances your NAV. Not surprisingly, debt funds are emerging as a strong alternative to bank FDs. Remember, you have credit opportunity funds and flexi funds where fund managers are more like active fund managers and tweak portfolios based on their view.
Liquid and Liquid Plus Funds
In terms of maturity, the liquid funds are short term funds and hence will compare more with short term deposits and savings deposits compared to long term FDs. Liquid funds make a lot more sense when the maturity of your liability is approaching. Debt funds while being secure tend to have a liquidity risk if there is a strong component of non-government debt in them. Also liquid funds can be used to temporarily park funds for the short term and earn higher yields. Since these funds do not charge exit load, they offer low cost entry and exit. However, only liquid funds are free of exit loads and some of the liquid-plus funds do charge an exit load. You need to be cautious of that.
Monthly Income Plans (MIPs)
Monthly income plans or MIPs are also debt funds with the difference being that MIPs are closed-ended funds. Once they are issued, entry to the MIP is closed and any exit is possible only through the listing on the stock exchange. MIPs are very useful when you have a fixed liability maturing at the end of a fixed period. In these cases, you can take an MIP whose maturity matches with your liability. This way, not only is your MIP a virtually assured return scheme but your liability is also perfectly matched. MIPs have emerged as an important instrument in the last few years.
Arbitrage funds are essentially equity funds which lock in arbitrage opportunities by selling equivalent quantum of futures at a premium. This way the gap between the spot price and the futures price is locked in and the yield is realized either by reversing the arbitrage position or by rolling over the future position each month. Arbitrage funds also give yields in the range of 8-9% and this rate can go up much higher when the stock markets become volatile. The big advantage of these arbitrage funds is that they are classified as equity funds as more than 65% of the exposure is in equities. Thus there is no withholding tax on dividends and any capital gain beyond 1 year is entirely tax free. The attractiveness of arbitrage funds is contingent on the volatility in the equity markets and the spreads in the futures market.
As is clear, there are a variety of instruments available to you to get a combination of safety and regular income. The big trend is that debt funds are emerging as a veritable alternative to bank FDs. That could be the big takeaway!