Why UHNI Investors Are Seeking Alternatives to Traditional Fixed Income Investments

The Shift in Fixed Income Investment

Since April 2023, fixed income investing has become less attractive for many investors, primarily due to changes in capital gains taxation. Returns from debt mutual funds, after accounting for taxes, expenses, and inflation (5.5%) have turned negative.

This has prompted investors to explore alternative strategies to achieve positive net returns. Below are some key alternatives:

1. Arbitrage Funds: A Low-Risk Strategy for Volatile Markets

What Are Arbitrage Funds?

Arbitrage funds are designed to capitalize on price differences between equity and derivatives markets through simultaneous buy-sell trades. Some arbitrage funds can also have fixed income positions to cushion the portfolio with accruals and at times benefit from interest rate changes.

Taxation

• Long-term holdings (over 12 months): Taxed at 12.5%.
• Short-term holdings (less than 12 months): Taxed at 20%.

Why Consider Arbitrage Funds?

Over the past year, arbitrage funds have delivered average returns of 7.33% (as of 28th Oct 2024). After factoring in taxes and inflation, they have outperformed debt mutual funds by around 200 basis points, offering a clear advantage.

Long-Term Considerations

However, opportunities for arbitrage can dry up, especially in low-volatility markets, causing long-term returns to dip below 5%, which can erode net returns after accounting for taxes, expenses, and inflation.

2. Hybrid Funds: Balancing Risk and Return

For investors willing to take on slightly more risk, Dynamic Asset Allocation Funds offer flexibility by shifting between equity and debt based on market conditions. These funds provide a diversified approach that can reduce exposure to equity while maintaining growth potential.

Taxation

• Funds holding 35% to 65% equity are taxed at 12.5% for long-term holdings (over 24 months).
• Some hybrid funds focus on a blend of debt and arbitrage, generating returns averaging 8%, which remains attractive even when reduced to 7% after accounting for taxes and inflation.

Why Consider Hybrid Funds?

Hybrid funds offer a dynamic approach for investors who are comfortable navigating market volatility, with the potential for strong returns and balanced risk exposure.

3. Listed REITs and InvITs: Income from Real Estate and Infrastructure

Real Estate Investment Trusts (REITs)

REITs provide exposure to income-generating commercial real estate such as office buildings, warehouses, and shopping centers. Currently, four REITs are listed in India: Embassy Office Parks, Mindspace Business Parks, Brookfield India, and Nexus Select.

• Distribution Yields: Range between 5.5% and 7.5%, with additional potential for capital gains or losses depending on price movements
• Liquidity: Daily trading volumes on exchanges range from ₹1.75 crores to ₹7.20 crores, so liquidity is a factor to consider.

Infrastructure Investment Trusts (InvITs)

InvITs allow direct investment in infrastructure projects. Notable listed InvITs include Powergrid, IRB, and India Grid Trust.

• Distribution Yields: Range from 2% to 11%, though returns may be impacted by price movements.
• Liquidity: Trading volumes range from ₹2 crores to ₹7 crores per day, making liquidity an important consideration.

Taxation for REITs and InvITs

• The holding period for long-term capital gains has been reduced from 36 months to 12 months.
• Long-term capital gains are taxed at 12.5%, while short-term capital gains are taxed at 20%.

REITs and InvITs allow investors to participate in the growth of India’s commercial and infrastructure sectors. However, liquidity, taxation, and the volatility of yields should be carefully considered.

4. Private Credit AIFs: A Rising Star in Debt Financing

Private credit refers to non-bank lending for non-investment grade companies, with a growing focus on small and medium-sized enterprises (SMEs) in India. This asset class has gained traction as an alternative source of capital for both startups and established businesses.

Why the Rise in Private Credit?

• Regulatory Limits: RBI restrictions on bank lending have created a credit gap in high-yield segments.
• NBFC Challenges: The IL&FS and DHFL crises, driven by asset-liability mismatches, led to stricter RBI norms.
• Liquidity Concerns in Mutual Funds: Incidents like the Franklin Templeton liquidity crisis in April 2020 highlighted the risks associated with mutual fund investments, especially during market stress.

Why Consider Private Credit?

Offering higher yields due to an illiquidity premium, private credit investments outperform traditional fixed income investments.For example, AAA or AA bonds in India may yield 0.5% to 1% more than government bonds, with potential spreads up to 10% further down the credit spectrum.

Private credit has emerged as a powerful alternative, especially for investors willing to explore beyond conventional debt.However, one needs to have a tenure of 5-6 years in mind while investing with an expectation of around 10% gross annual cash flow and the rest back ended in the case of performing credit funds.

In conclusion

As traditional fixed income investments options face challenges, these fixed income alternative investment avenues offer promising opportunities for enhancing portfolios. From the strategic benefits of arbitrage and hybrid funds to the growth potential of REITs and InvITs, each caters to varying risk appetites and financial objectives. Additionally, the rise of private credit highlights the evolving investment landscape, providing access to high-yield opportunities. Ultimately, thorough research and an understanding of each alternative’s risks and rewards are essential for making informed decisions that align with individual financial goals in this dynamic market.