Money managers and financial advisors, when pitching financial products to you, love to cite Einstein on compounding being the eighth wonder of the world. Then, they do their best to convince you that if you want to benefit from compounding, you should be maxing out your equity investments. But if you give it a bit of thought, debt investments often turn out to be more predictable compounders of wealth for Indian investors, than equities.
Steadier compounding
In equities, your returns come in fits and starts. You may make a 30 per cent return one year, lose 15 per cent of it in the second year and gain back 10 per cent in the third year. But such zig-zag returns from stock prices don’t really make for steady compounding of your money.
So, when equity fans praise the magic of compounding, what they’re really talking about is owning great companies that manage secular profit growth, reinvest it in their business at high rates of return and thus deliver high earnings compounding, which eventually leads to stock price returns. But then very few companies manage to achieve such earnings consistency in real life. To identify them, you’ve got to be extremely skilled or very lucky.
When you take the mutual fund or index route to equities, your compounding happens at a much lower rate, depending on your timing and staying power. A rolling return analysis of the Nifty50 Total Return Index over the last 20 years tells us that there have been quite a number of occasions (13 per cent of the times) when the Indian market has delivered a less than 7 per cent CAGR to investors with a five-year holding period. Even a 10-year holding period doesn’t guarantee compounding at a high rate. Folks who bought into Nifty 50 in end-2007 and held till 2017 earned less than an FD CAGR of 7 per cent from the Nifty50.
Debt instruments, in contrast, offer greater certainty of compounding. This is why, while making debt allocations towards long-term goals such as children’s education, the purchase of property or retirement, you should pay close attention to whether your interest compounds, to create wealth.
Choice of instruments
Here are ways to ensure that your debt money compounds.
While investing in fixed deposits or non-convertible debentures, choose the cumulative option as your default. If you opt for income, the interest from the deposit can land in your bank account and get spent before you know it.
Prefer instruments with compounded interest even if their interest rate is slightly lower. Today, the seven-year Government of India’s Floating Rate Savings Bond offering a 7.15 per cent interest is one of the most attractive debt options in the market. But this bond has only a payout option and no cumulative option. So, if you’re looking for a debt instrument for your long-term goals, the Public Provident Fund with its tax-free interest, despite its 15-year tenure, is a better choice (unfortunately you can invest only ₹1.5 lakh of your annual savings in it).
If you choose a regular payout debt instrument owing to its safety or high returns, open a separate bank account for your interest receipts and make it a habit to reinvest the balances frequently. This will ensure that your interest receipts compound.
When seeking compounding, do it with sovereign-backed instruments or pedigreed AAA-rated issuers and not with lower-rated entities that offer higher rates. With cumulative options of NCDs, FDs or deposits, you’re allowing the borrower to hang on to your money until maturity. It is not worth risking your principal for higher compound interest.
The manner in which your returns are taxed also affects the rate of compounding. In the case of FDs or NCDs, interest on the cumulative option is added to your income every year and taxed. But with debt mutual funds, if held beyond three years, returns are taxed as long-term capital gains with indexation.
Compounding options
If you’re seeking compound interest, post office schemes offer you the best bet in terms of safety. But then, popular options such as the 5-year time deposits, Monthly Income Account and Senior Citizens Savings Scheme offer only interest payout options and no cumulative options. 5 year plus FDs with leading banks or highly rated NBFCs offer cumulative options, but unfriendly taxation takes a bite out of your returns.
For 3-5 years, accrual debt funds (categories such as corporate bond funds, PSU & Banking Funds and short-duration funds) and Fixed Maturity Plans are good choices. Funds that rely on duration gains (gilt funds, medium duration and dynamic bond funds) behave a little like equities and are less desirable for consistent compounding. For 5 to 7-year horizons, the post office National Savings Certificates and NCDs from top-quality NBFCs make for good choices.
For horizons stretching to 10 years and beyond, the Public Provident Fund, is a great compounding option. For retirement, your EPF account is a good choice. For most investors, the National Pension System flies under the radar as a long-term debt investment. Allocating high proportions of your annual NPS contributions to the C (corporate bond) and G (government bond) options can compound your debt money at a high rate. If you want to withdraw before you turn 60, use the same choices in the NPS Tier 2 account.
While many regular income options are available on tap, cumulative options such as high-quality NCDs, tax-free bonds and FMPs come up only once in a blue moon. Rarely do these issues coincide with an upcycle in interest rates. Therefore, always hold some portion of your long-term debt money in accrual debt funds and switch the money into such options when they do crop up.