Loan vs Redemption of Mutual Funds

In our lives, we will occasionally face the question, “Loan vs Redemption of Mutual Funds”. Suppose I want to buy a home the question arises, “should I take a home loan or redeem a mutual fund investment”? This question is quite deep, complex and serious. We need to discuss it carefully and in detail.

Loan is Bad

Undoubtedly debt, in general, is bad and you should avoid it. Value Investing exhorts to shun commercial borrowing as you would plague. The careless habit of borrowing and use of credit cards will create an unbearable debt burden. I feel sad seeing a number of bright youngsters working in wonderful companies and drawing handsome salaries but borrowing beyond their means through multiple loans and credit cards. They struggle to pay monthly EMIs and manage them by juggling through various cards.

Can we totally avoid taking loans? 

No, we can't always avoid a loan. Any useful and long-term expenditure that involves huge upfront cash outflow and which is beyond one's means may need taking a loan. Following are a few examples relevant for India:

1. Purchase or construction of a home - Avail a home loan
2. Buying an automobile - please note carefully my advice about cars later in this post
3. Child's higher education

Daughter's marriage is expensive and a big responsibility in India. Son's marriage is no less but compared to the former it is lighter. Please don't think I have gender biases - I have none. On the other hand, I have great respect for and confidence in girls. Still marrying off a daughter in India is a big responsibility.

I don't recommend borrowing for marriage. It is better to do the marriage function from savings. Like breaking fixed deposits created for this purpose. In the extreme instance, you may take interest-free loans from the organisation where you work or relatives and friends. You may ask me why this distinction even though the daughter's marriage is a huge, long-term and one-time cost. The reason is while the other situations I described above have some material utility daughter's marriage is a pure personal responsibility and expense

How to decide between loan vs redemption of mutual funds?

Don't Redeem Mutual Funds for Short-term Needs

Mutual fund investments are long-term investments. History shows that over very long periods of time mutual funds create unimaginable wealth. So to redeem mutual funds to meet short-term needs is squandering a valuable opportunity to create wealth.

So what are short-term needs? Here are a few examples:

1. Paying a child's monthly school fees
2. Going on a vacation
3. Paying the monthly loan EMI
4. Paying credit card dues
5. Paying personal Income Tax

I have listed only a few examples. I urge you to make a more exhaustive list for yourself. 

You should meet short-term needs only through your regular earnings. You should never redeem mutual funds for them.

In order to easily meet short-term liabilities, you have to learn to live a simple life. You should avoid the urge to splurge. My guru Warren Buffett says, "If you buy things you don't need, soon you will have to sell the things you need".

Redeem Only for Purchasing an Equally Long-term and Appreciating Asset

You should never redeem your mutual fund in your lifetime. This is my firm view. However, if you ever have to redeem, it should be for an equally long-term asset with the same attractive capital appreciation. For example, purchasing a home or a high rent yielding immovable property.

Even for buying immovable property like land and buildings, I don't recommend redeeming mutual fund. But if there is no other way we can at best pardon it. Let me narrate experience in a similar situation.

I was buying a piece of land in Uttarakhand for constructing our retirement home. The price was eight lakhs. I broke down fixed deposits lying in banks and mobilized from other sources. There was a final gap of one and a half lakh rupees. My wife was having a mutual fund a Systematic Investment Plan (SIP) actually, valued three lakh rupees. With a heavy heart, I asked her to redeem half of it. We purchased the piece of land. I have taken a home loan to build the house. So if we look at it we redeemed a mutual fund but only a small part of the project cost.

Don't redeem mutual fund to buy a useless, depreciable asset like a car

Buying a car is a bad idea. But in India where public transport is not ideal, an automobile is essential. However, don't buy expensive and luxury cars. Further, keep the car for at least 10 to 15 years. Don't keep changing cars or models often say in three to five years. 

The car is a highly depreciating asset. The moment it comes out of the showroom it will lose 10 per cent of its value. The value further depreciates ten per cent every year of use. I have not counted the expenses of petrol, repairs and insurance yet. 

Finally, it is not an asset but actually a liability.

Don't redeem your valuable mutual fund to buy an actual liability like the car.

Summary

The 'Loan vs Redemption of Mutual Fund' is a tricky question. Both loans and redeeming mutual fund shall be avoided. Under certain circumstances, they may be sparingly used as described above.  

Debt Funded Dividends?

A recent research report by India Ratings and Research, a Fitch group of companies has shown that though the quantum of debt funded dividends have come down still many of the corporates are paying dividends out of borrowed funds.

The study is based on the study of the top 500 corporate borrowers. Of these 500 corporates 65 companies account for 85-88% of the total dividends paid since FY 2010, and hence these 65 companies have been studied.

The 65 companies are classified into three categories:

1. Category A: Free Cash Flows (FCF) are positive and greater than the dividends paid (FCF +ve & > Dividend)
2. Category B: Free Cash Flows (FCF) are positive but less than the dividends paid (FCF +ve but < Dividend)
3. Category C: Free Cash Flows (FCF) are negative and the entire dividends paid id funded by debt (FCF -ve & entirely funded by debt)

The summary of the research report reveals:

Debt Funding of Dividends (DFDs) Shows Downward Trend:

From a level of 22% of the total dividend in the financial years 2010-16, DFDs will decline to an estimated 13%. 

In absolute terms too the DFDs are estimated to come down from an absolute figure of Indian Rupees 90 billion to 58 billion.

Capital Intensive Sectors to be the Main Culprits:

Capital intensive sectors like infrastructure, telecom and power are the main contributors. The reason being the profits are fully absorbed for creation of capital assets and therefore are forced to borrow to pay dividends.

DFDs of capital intensive sectors which contributed 42% of the total in FY 2010-16 are likely to steeply climb to 77% in FY2017-18.

Healthy Corporates to Pay Higher Dividend

Ind-Ra expects the Category A companies to pay higher dividends than focus on growth (at the cost of dividends).

The CAGR in dividends grew at 21% compared to the CAGR growth of 6% in free cash flows.

Unwarranted Dividends by Riskier, Category C Companies

The riskier, Category C companies, wherein dividends are 100% financed by debt, the dividend payout grew at a 11% CAGR between FY 2016 and FY 2010.

Ind-Ra predicts that the possible reason for growth in debt funded dividends is to defend the market capitalisation. It is observed that the market capitalisation of the Category C companies increased 2% despite their free cash flows being negative since the financial year 2012.

In conclusion, debt funded dividends is a horrendous practice and value investors should shun investing in such companies.