Financial Planning: Debt Portfolio Construction

Debt forms an integral part of any portfolio. The importance of Debt can’t be emphasized enough. I am not going over why Debt is important. There is enough literature around to explain and illustrate the importance of debt.

This post is more on the avenues of debt that are available for investment, the reasons for investing into them, individual pros and cons and finally, what would I do. This post is more from sharing an experience perspective.

Prologue:

Emergency fund is an important part of financial planning. The emergency fund is typically made of instruments that are highly liquid and can be retrieved at a very short notice. Typically, these are kept away from market linked instruments like equity as the very objective of this fund is capital preservation.

Emergency fund may contain FDs which may need a relook mainly due to tax inefficiencies of the same. However, emergency fund may also contain Debt funds (described below) and hence, this prologue.

VPF, PPF, Sukanya Samriddhi (SSA)

All salaried individuals are familiar with the PF contribution from the salary. However, there is an underlying power of this instrument in long term retirement planning. First of all, we need to understand the tax implications of any instrument. PF falls into the EEE category where it’s exempt from tax as per the current rules. Typically, the PF rate hovers around 8 – 9 % which is an excellent post tax (or zero tax) return. Hence, PF should be an integral part of any debt portfolio.

The PF contribution that is deducted in office is called EPF i.e. Employee Provident Fund. Typically, this is made up of 12% of basic from employee’s contribution plus 12% of basic minus 1250 (pension scheme) from employer’s contribution.

However, there are other avenues where one can invest into these kind of instruments. For example, most companies allow employees to increase their own contribution through VPF (Voluntary PF contribution). Here, an employee can increase their contribution upto 100% of basic. Since, 12% deduction is already present, an employee can top-up/add another 88% of basic as VPF. Do note some important gotchas below:

  • This is an employee only contribution. Employers WILL NOT match this contribution.
  • Some companies may not offer this facility. Please check with your organization.
  • This is NOT a separate account. All contributions are credited to the same PF number/UAN.
  • When a transfer is initiated, all contributions are automatically transferred.
  • Interest rate is same as EPF rate.

Along with VPF, interested individuals can opt for PPF (Public Provident Fund) contributions. These accounts can be opened in a Post office or a bank. Some important gotchas w.r.t. PPF as below:

  • You can open account in your name or kids’ name
  • Total contribution across all PPF accounts (Self & Minor) can’t exceed Rs. 1.5 Lakhs per year
  • Interest rate is same as EPF rate

Last year, Government of India launched a new scheme for girl children below 10 years called Sukanya Samriddhi Scheme (SSA) opened in post offices or banks. This scheme is similar to PF and enjoys a relatively higher Rate of Interest (PF Rate + 0.4%). Some features below:

  • Max Investment: Rs. 1.5 lakh per year
  • Interest rate is PF rate + 0.4%
  • Investment period: 14 years
  • Maturity:21 years after opening account or when the girl gets married
  • Partial Withdrawal when the girl attains 18 years of age

An individual can consider to increase VPF contribution based on cash flow perspective, maximize PPF contributions and if a girl child is there, maximize SSA contribution. Please note that SSA contribution is over and above PPF contribution.

Note: All these instruments are highly illiquid and mainly intended for retirement or Girl Child’s education and/or marriage.

Tax Free Bonds

As the name suggests, the interest earned from these bonds are tax free. These bonds are typically available for 10 year, 15 year and 20 year periods with very good interest rates. Some salient features of these bonds are:

  • Can be traded in secondary market
  • Every year, interest is credited into the account
  • Capital is returned at the end of tenure
  • Can be employed to create a steady flow of annual income
  • Excellent instrument from a tax perspective

Personally, I am considering a portfolio to create a steady income to fulfill some of my needs through these bonds. This is a definite must in a debt portfolio.

Fixed Maturity Plans (FMP)

These are closed ended funds from AMCs. Typically, their returns are similar to FD rates. Where FMP scores over FDs is that from a tax perspective, beyond 3 years, FMPs are taxed at same rate as Debt Funds (20% with indexation).

Debt Funds

Debt funds are the most commonly employed MF instruments for Debt Portfolio construction. A list of different types of debt funds are available as part of Mint50 or FundsIndia Select Funds in my previous post. Some points to note:

  • Redemption before 3 years – Profit added to Income  – Taxed @ individual tax slab
  • Redemption after 3 years – Tax = 20% with indexation
  • Highly Liquid – Funds are available in T + 1 date
  • Carries a market risk and interest rate risk

So, what should one do..

Personally, I feel one should invest in all these avenues as part of goal planning or debt portfolio creation. Please do study these instruments, understand the risks before investment. However, one important point which is often not considered is the tax implications of the instrument. Take a judicious call after analyzing all angles.

Stay Healthy.. Stay Financially Healthy…

 

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