Evaluating Investment options -Debt & equity

The decision to invest surplus funds between Debt and equity must be based on a thorough analysis of various factors and after considering specific business circumstances, needs, and goals.

This article includes the following aspects related to the evaluation of investments.

AA) List of parameters that guide the choice of Debt vs. Equity.

BB) Evaluating parameters for choosing among MF options

CC) Debt-based options to invest, estimated returns, and risks

DD) Equity-based Options to invest, estimated returns, and risks

EE) Hybrid-based options to invest, estimated returns, and risks

AA) List of parameters that guide the choice of Debt vs. Equity

The parameters are listed below.

i)Risk appetite refers to the company’s willingness to invest based on acceptable risk levels based on conducting risk analysis on several aspects, such as below.

·      Market volatility risks

·      Liquidity risks

·      Credit risks

·      Operational risks

·      Regulatory risks

Equity is considered a higher-risk investment than debt, as no return guarantee exists.

Further, If the business is already heavily leveraged with debt, taking more debt may increase financial risks.

ii) Investment time horizon and liquidity: Review parameters include:

·      Funds for short-term business needs

·      Funds for long-term business needs

·      Lock in periods

 Debt is a good option for short-term investors, as the returns are relatively predictable.

Debt is more liquid than equity and easily convertible into cash. Equity may take longer to sell and realise profits.

iii) The financial objectives can be as follows:

·      Maximizing return

·      Diversifying investments

·      Generating cash flows

·      Funding future projects

·      and so on

If the funds are required for long-term purposes like expansion, with a longer life span, then Debt financing may be suitable, whereas equity could be the option for working capital.

iv) Cash flow analysis from investments based on

·      Outflows to:

§  Buy treasury stocks, bonds,

§  Debt payments  

§  Dividend payouts

§  Interest payments   

And so on

·      Inflows from:

§  Dividend earnings

§  Interest earnings

§  Sale of equities/stocks

§  Sale of bonds

§  Sale of preference shares

And so on

 Cash flow from analysis of investments helps to determine the quality of investment.

v) Regulatory compliances 

·      Regulatory restrictions/limits specific to the industry

·      Corporate governance guidelines

        vi) Credit Quality 

§  Credit rating of the issuer of a debt instrument

§  Credit rating of the Company offering Fixed Deposits

And so on

          The credit ratings provide valuable inputs on risks to make informed

         Decisions before investing in debt funds

vii) Costs associated with investment

§  Transaction fee

§  Management fee

And so on

 viii) Tax implications

§  Long-term capital gain tax

§  Short-term capital gain tax

§  Tax deductibility for interest on loans

Any other tax

 Interest payments on debt are often tax-deductible, which can provide a tax advantage compared to issuing new equity.

 ix) Market/economic conditions 

·      Inflation: When inflation is high, the value of money decreases,

which means that debt investments become less valuable. Equity investments can protect investors from inflation.

• Interest rates: When interest rates are high, the debt investments' cost increases, making them less attractive to investors.

·      Exchange rates

·      Liquidity in the market: During economic slowdown, the possibility of default on Debt interest and Principal are high and hence risky

xi) Environmental and governance matters

§  Impact of Investment on Environments /Sustainability

§  Corporate governance obligations

§  Social responsibility

   BB) Evaluating parameters for choosing among MF options

A mutual fund is an investment vehicle that mobilises funds from different investors to achieve a common investment objective. Funds are raised by selling the fund's units, representing contributions to the mutual fund corpus.

Evaluating criteria for choosing MF include:

·      The financial goal in terms of:

§   Returns expected,

§  Investment time horizon

·      The risk level is acceptable to investors with funds being evaluated.

·      Expense ratio in terms of annual charge and exit load.

·      Funds’ past performance: Last three years and five years’ returns

·      Fund managers (through whom MF is invested) track performance, qualification, experience, etc.

An overview of the Indian market (having more than 3000 + options) offers opportunity to invest in following options.  

§  1. Debt

§  2. Equity

§  3. Hybrid

CC) Debt-based options to invest, estimated returns, and risks

Debt-related options can be categorised under (3) categories.

·      1Debt -Fixed income -for different durations

·      2Debt -Others (like money market, corporate bonds, Gilts, sovereign bonds, overnight, etc)

·      3Debt -Fixed maturity

Debt funds invest primarily in fixed-income instruments like below:

·      1. Government securities,

·      2.Treasury bills,

·      3.Bonds:

§  Govt bonds

§  Banking &PSU bonds

§  Financial institution bonds

§  Municipal bonds

§  Corporate bonds,

§  Credit risk bonds,

·      4. Debentures,

·      5.Certificates of deposits, etc.

Debt funds are aimed at providing regular and stable returns while protecting capital. 

Debt instruments can be of different durations, as mentioned below:

§  Long duration (7 years or above),

§  Medium to long-term duration (4-7 years),

§  Short duration (1-3 years),

§  Low duration (6-12 months),

§  Ultra-short duration (3-6 months),

§  Liquid funds (91 days),

§  Overnight funds (1 day)

§  Fixed maturity plans

Returns on investment can vary considerably based on Market and economic conditions, political stability, Governance matters, and statutory environments.

The indicative range of “Return” (In the Indian market) for “Debt funds” is 4-7 of % in Q2-FY 2023-24.

The “Risk Ratings” of Debt funds (considered in 3-5 years) is estimated.

 Low. However, Debt Investments backed by Govt are risk-free.

DD) Equity-based Options to invest, estimated returns, and risks

Equity-based options are primarily under (5) categories.  

·      Equity: -Size driven

·      Equity: -Value & Tax driven

·      Equity: -sectoral specific 

·      Equity: -Thematic

·      Equity: -International

·      Equity funds invest most of their assets in stocks and related instruments. Equity funds are ideal for investors with high returns and higher risk tolerance.

     Equity funds can be invested in companies with different market caps.

·      Market capitalization can be defined as the total no of a company’s.

Outstanding shares Multiplied by the Current stock price.

·      In the Indian context, the following types of MF-Equity funds options are available.

·      Lage-cap, wherein funds are usually invested in Top 100 stocks in companies that are well established, have large market shares, and financially stable, and generate consistent returns.

·      Mid-cap, wherein funds are usually invested in Top 101-250 stocks in companies having Higher growth potential than large-cap, offer a balance between growth & risk.

·      Small-cap wherein funds are usually invested in stocks lower than 250 stocks in companies having Higher growth potential than mid-cap

·      Multi-cap, wherein there is flexibility to invest in small large cap companies.

·      Flex -cap where in Fund managers can dynamically allocate funds to large-mid-small

The indicative range of “Return” (In the Indian market) for Equity funds is 4-6 times the returns on Debt funds on 3-5 Years average in Q2-FY 2023-24. It can vary from period to period.

The “Risk Ratings” of Equity funds (considered in 3-5 years period) is estimated “High”.

Such returns are based on month-end net asset value (NAVs), assuming.

Dividend reinvestment and readjusted for any bonus or rights.

EE) Hybrid-based options to invest, estimated returns, and risks

 Hybrid Funds options can be divided in (5) categories.

§  1. Aggressive hybrid where 65-80% of funds are equity-based & rest Debt.

§  2. Balanced hybrid 40-60 % of funds are equity-based & rest are Debt.

§  3. Conservative, where 10-25 % of funds are equity-based & rest Debt.

§  4. Dynamic asset allocation funds where funds are managed dynamically between equity and Debts.

§  5. Gold funds

As is evident, Hybrid funds invest in stocks and debt to offer balanced returns and risks. Their asset allocation will differ based on their mix of equity and debt.

The indicative range of “Return” (In the Indian market) for “Hybrid funds” is 3-5 times the returns on Debt funds on 3-5 Years average in Q2-FY 2023-24. It can vary from period to period.

The “Risk Ratings” of Hybrid funds is estimated Average.

Aspects related to other investment options like Direct stock investments, Fixed deposits, commercial papers, Money market instruments. Real Estate, Derivatives and investments overseas are not included in this blog.

Potential activities (including unethical) that can adversely impact business.

Common for all investments: Inaccurate capturing of evaluation parameters for investment options

MF

·      Inadequate study of the following before choosing the MF to be invested.

§  Funds’ past performance: Last three years and five years’ returns

§  Expense ratio in terms of annual charge and exit load.

·      A non-comprehensive risk assessment by the Fund manager and not spreading the investments in various MF buckets options available.

·      Investing patterns not aligned with financial objectives.

Debt Funds

·      Inadequate evaluation of Debt options and their documentation before investing

·      A non-comprehensive risk assessment by inexperienced team members 

·      Investing in instruments in debt instruments of companies who offer kickbacks, i.e., investment not at arm’s length.

·      Investing in debt instruments while compromising on statutory requirements

Equity funds

·      Inadequate evaluation of the following before choosing stocks to invest:

·      Investment Goals: Long-term growth, Regular income, Capital preservation, Or a combination

·      Risk Assessment: Current financial situation, Market volatility, Economic conditions

·      Financial performances of the Target company: Revenue growth, Cash flows, Profitability, Return on equity, Debt ratios, Dividend policy.

·      Valuation of the target company: Share price in the market, Price-to-earnings ratio, Price-to-sales ratio, Dividend yield.

·       Management team of the target company: Experience of the leadership team, Reputation in the Industry, Ethical values, Value to shareholders.

·       Analyst’s report and rating: Reports giving various matrices, Rating of the company vis a vis Industry, Outlook.

·       Tax implications.