Saturday, April 18, 2009

Alternate Investments with fixed income features

Alternate Fixed Income Investments

In the previous blog post I spoke of options available for fixed investments. Some of the questions that a few people came back with were, ‘why does one need to look at the various options? How much difference – in terms of returns – can one seek to achieve? Is spending the time to understand the options worth the trouble at all?

Even a 0.5% annualized improvement in annualized returns can bring about a meaningful improvement in the investment income over time. Let me elaborate. Consider someone – let’s call her Richa- with a crore of investments in fixed income securities. Let’s assume Richa has no other income streams and intends to live on the returns from the investments and the draw down from the investments. Let’s further assume that she expects to be around for fifty years and wants the investment to support her for that period. Let’s assume that inflation will be at 5.5% over this period. The following table shows the monthly spend she can afford, at different rates of return

6%                   Rs 19,500, approximately

6.5%                Rs 21.800, approximately

7%                   Rs 24,350 approximately

As can be seen, a 1% annualized improvement in returns can support a close to 25% improvement in the spend Richa can afford, implying a better lifestyle! Another way of looking at this is that to afford the same kind of spend – Rs 24.35K- at 6%, Richa would need a sum of Rs 1.25 crores.

That should settle the need for looking for investment options that offer potentially better returns that the popular options.

Alternate Fixed Income Options

There are a few ‘fixed income like’ options that have characteristics very similar to fixed income investments. I discuss a couple of those here.

Equity arbitrage funds: These are funds that try to take advantage of the arbitrage opportunities available in the stock market, primarily the arbitrage between the cash and futures markets. To illustrate, consider a stock quoting at Rs 102 in the cash market and Rs 100 in the futures market. An arbitrage fund sells the stock in the spot market and buys futures (or vice versa), pocketing the difference. Of course there are costs here, like the cost of carrying the futures position, the cost of executing the trades etc. These funds make money as long as the arbitrage is large enough to cover the costs and more, failing which one could expect them to deliver liquid fund kind of returns over time.

The arbitrage funds have delivered well over the last two years, both in the bull market of 2007 and the bear market of 2008. The returns have been in the range of 8-9% annualized. The fun thing is that these are classified as equity funds and as such there is no long term capital gains tax here. The short term gains are taxed at the applicable rate. It gets even more interesting if one were to opt for the dividend option with these funds. The funds don’t pay out any dividend distribution taxes and the dividends are free in the hands of the investors as well. Potentially all the gains could be had – completely tax free- in the form of dividends! In such a scenario, the 8-9% post tax return translates to a 12-13.5% pre tax return, approximately. That beats all the bank deposits, etc, hands down.

A word of caution here. There have been months when the returns from the arbitrage funds have been bad, of the order of 1-2% annualized. There have been months when the returns have been far better, with the result that the performance over a year has been good. So, if you have a tenure of a year or more, you may want to consider the equity arbitrage funds.

Structured bonds: Certain banks offer structured notes – which offer capital protection and a guaranteed coupon (interest rate) – while allowing the investor to participate in the upside offered by the equity markets. A structure that I recently came across worked as follows

  • Capital protection -100%
  • Coupon – 8% annualized
  • Market participation – 40%
  • Knockout – 35%, which means that if the stock market rose by more than 35% during the tenure of the note, the investor would get only the capital and the guaranteed coupon
  • Tenure – 18 months

The returns would occur in the form of capital gains, making the structure reasonably tax efficient.

These bonds are not for everyone, as the investors are exposed to counterparty risk here. If the note issuing institution goes bankrupt, the investor could lose everything. Also, there is the issue of locking up of one's funds for 18 months.

Having said the above, the institutions that issue such notes are, usually, on fairly sound footing as per my reckoning, with decent credit ratings. So, one is not talking junk bonds here.

I think these notes would make sense to an investor who understands and is comfortable with the counterparty risk, is willing to forego the liquidity, to participate in the upside of the equity markets, while protecting one's capital and a base minimum return on one's funds.

Closing note

My attempt through this blog has been to bring to the notice of readers, the things they need to do to succeed in their quest for financial freedom. I have touched upon the need for asset allocation, the way to go about the same, the importance of insurance and some of the asset classes. I intend to discuss the riskier asset classes, real estate and equities, going forward.


Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

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