Why using interest from debt investments for SIP is a flawed strategy

Companies are coming up attractive interest rates on non-convertible debentures (NCD) issues. M&M Financial services will be offering 9.05 – 9.5 per cent on its NCDs opening that will open on January 4. Shriram Transport Finance issue that opens on January 7 will offer interest rates of 9.12-9.70 per cent. The rates vary with the tenure – longer the investment period, higher the interest rate offered.

Interesting, some distributors are suggesting investors put money in such NCD issues, opt for a monthly payout of interest income and use the amount for a systematic investment plan (SIP) in an equity fund. Distributors are recommending this strategy to clients who are either first-time equity investor or are wary of the volatility in equity. With this strategy, an investor can also get to preserve his capital.

But investment advisors advise against this strategy. “Equities help investors to earn higher returns over a long horizon despite the volatility. The investor can make much higher returns if he invests the entire money in an equity fund instead of just the interest portion from a fixed instrument,” says Kartik Jhaveri, director, Transcend Consulting. Jhaveri says that if a person is not comfortable with volatility, it’s best to stick to fixed deposits. But if an individual has no option but to invest in equities for higher returns to meet his goals, then he has to live with the volatility. “There is no other way to create wealth and reach your goals,” says Jhaveri.

When a distributor shows the calculation, you will see there’s not much difference between investing all the amount in equity versus investing the interest portion through a SIP. If an individual invests Rs 12 lakh in an NCD that gives a return of 9.5 per cent for 10 years with a monthly payout option, he will get around Rs 9,500. He uses this amount for an SIP of 10 years. If the investment grows at a compounded annual rate of 12 per cent, he will have an equity corpus of about Rs 22 lakh after a decade, which is his gains. In addition, his capital of Rs 12 lakh is preserved.

Say, the investor puts all the money in an equity mutual fund, and it grows at 12 per cent every year. After 10 years, he will have a corpus of Rs 37.27 lakh, which means his returns are Rs 25.27 lakh. The difference that a distributor will show is mere Rs 3.2 lakh.

But this calculation that a distributor shows an investor is without taking taxes into account. If a person in the 30 per cent tax bracket receives Rs 9,500 a month, he will also need to pay a maximum tax of Rs 2,850. It means, the SIP amount drops to Rs 6,650. For someone in 20 per cent tax bracket, the monthly SIP amount will be Rs 7,600. If a person takes the taxes into consideration, the difference is much wider than what a distributor shows. Also, if you are using the NCD payout, you could be taxed twice – once on the NCD returns and second, if you withdraw over Rs 100,000 from equities in a financial year.

When evaluating a financial product, don't just go by distributor's calculations. Do your own math before putting in the money.

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