Investing in equities versus debt
In a sense the debt markets are the same as the fixed income markets. They are called debt markets in India and fixed income markets in the United States. However, in India, the fixed income market is a much wider term which includes exchange traded and non-exchange traded debt while debt market is largely referred to exchange traded debt. When you talk of equity market and debt market, there are some basis differences on fixed parameters to remember. Equity trading is about risk assets while debt capital markets trading is about fixed income instruments. In this section we look at some of the key differences between debt and equity markets and we also look at some of the nuances of the debt and equity market overall.
How are the equity and debt markets different?
There are various parameters on which the equity market and the debt market can be compared and contrasted. Here are a few headers.
- Let us focus on the nature of relationship between the two parties to the instrument. While equities or shares of a company forms part of the capital of such company, the relationship of the equity shareholder with the company is that of a partial owner. In the case of debt market, the investors in the bond is a creditor or lender while the issuer of the bond is a borrower or debtor who owes debt to the investor.
- Equity and bonds also vary in terms of the nature of returns. The common thread is that equities give higher returns for higher risk while bonds give lower returns for lower risk. That is too generic. You need to qualify this statement a bit. In the short run, Equities have a higher risk than bonds and even the returns on the bonds can be higher than returns on equity. However, in the long run, equity is higher on returns and lower on risks and the longer time period automatically mitigates most of the risks.
- How do equity and debt fit into your portfolio? Equity is best cut for long term goals like retirement planning, saving for your children’s education etc. When you have a 15 year perspective, equities can work better in enhancing returns and also in reducing risk. However, for shorter term goals up to 5 years, it is always better to have predominance of debt as it is more predictable.
- What are the specific returns on equity and debt. In equity, the returns are in the form of dividends declared and paid by the company as well as capital gains when the company performs well. In addition, the shareholder also gains from corporate actions like bonus issues, rights, stock splits, buyback etc. In the case of debt, the interest is the only return to the bond holder and they just get back the principal at the end of the tenure of the bond.
- What are the risks in equity versus bonds? Let us start with equities. Equities are subject to systematic risks and unsystematic risks. Systematic risks are the macro risks that cannot be diversified like inflation, weak GDP growth, high interest rates, volatile currencies etc. It also includes political risk. On the other hand unsystematic risks pertain to the specific industry or company. What about debt. The most important risk in debt is price risk or the interest rate risk, which is the risk that prices of bonds will fall when interest rates go up. In addition, private debt also runs default risk. All debt instruments have inflation risk and the call risk in case the bonds are callable. So debt has its share of risks too.
- Finally, let us look at the taxation aspect in the case of equity and debt. Dividends received from equities are taxed in the hands of the investor at the applicable slab rates. Since the Budget 2020, dividends is being treated as other income and is at par with interest income. What about short term capital gains (STCG) and long term capital gains (LTCG). These are taxed at the rate of 15% and 10% respectively. There is a basic exemption available in the case of LTCG for net gains up to Rs1,00,000. What about debt? Interest received from debt instruments along with STCG is taxed at the applicable slab rates of the investor or the peak rate. LTCG is taxed at the rate of 20% after giving the benefit of inflation indexation. The exception is tax free interest bonds where the interest is totally tax free.Equity trading made easy with our platform. Buy and sell stocks with confidence, backed by advanced tools and market insights. Start trading now