As Bank FD Rates Fall, Where should we Invest in…

Over the past two years, RBI has reduced benchmark policy rate by 175 basis points (bps) to 6.25%. This has resulted into fall of FD rates offered by banks and also Small Saving Schemes viz. Public Provident Fund (PPF), NSC, postal savings schemes etc who have reduced the rates and  disappointing many investors who are looking to earn fixed returns. 

Bank FD’s were offering 8-9% just a couple of years back which has gone down to below 8% now.

The impact of falling interest rates…

For example if we have invested Rs. 10 lakhs in a one year FD earlier where it was fetching 9/5% quarterly compounding return it would have given annual interest of Rs 98438 (quarterly compounding) But with the current FD rates hovering around 7.5%, our yearly return on fresh deposits will be approximately Rs. 77136 – which is Rs. 21302 less as compared to earlier returns. Further this is taxable income so TDs may be deducted and we have to pay tax as per the slab rates. this is excluding tax.

So If we are placed in the highest tax bracket, the net yield from the bank FD will be in the range of 4.5-5%. Therefor if we calculate the real rate of return (also known also as inflation-adjusted return)  on FDs it will be actually negative considering 5% normal inflation rate.

Especially for Senior citizens, who depend on interest income to fund day-to-day expenses, this is a serious concern for managing their investments.

Hence, its demand of time to find out other options which can be used alternatively in place of Bank FDs and Small Saving Schemes.  Although we understand that bank fixed deposits or Small Savings Schemes are considered safe and easy to manage instruments still there is no dearth of fixed income products available which can give better risk return output. However As riskier assets command a higher yield; so here too, risk cannot be ignored. There is a gamut of other available investment avenues: corporate fixed deposits, corporate bonds, tax-free bonds, and debt mutual funds; albeit the fact that they command higher risk vis-à-vis bank FDs and SSS. Here are the pros and cons of each of these options. 

1. Corporate fixed deposits and corporate bonds: Corporate FDs and bonds earn you a higher interest than bank FDs. Currently they offer returns in the range of 8-9%. However, we should remember, the higher yield comes with a higher risk. The risk of default in corporate FDs cannot be ignored. So while investing in Corporate FDs ratings and reputation of company should be seriously analyzed and only top rated companies should be considered for investments. Due to the poor regulatory framework, there is little respite if the company fails to earn back your hard-earned money.

2. Tax-free Bonds: Tax-free bonds are a good long-term fixed income option, especially if investor is in the highest tax bracket and able to subscribe to the bonds in the primary market, as and when they are offered. As the name suggests, the interest earned on these bonds is tax-free. These bonds can be bought/sold in the secondary market also; however, liquidity can be an issue. Currently, there are no tax-free bonds available for subscription in the primary market, but as the financial year draws to a close, we may find quite a few in the offing. In the secondary market, the bonds are trading at a yield of around 6-6.25%. The post-tax returns work out better than the current bank FD rates; but liquidity may be an issue, or if yields move up, the possibility of a loss of capital cannot be ignored when sold prematurely.

3. Debt mutual funds:  Based on the fund investment mandate, debt funds invest in different securities such as government bonds, corporate bonds, corporate deposits, etc. with different maturities. In mutual funds the returns are not guaranteed as the investments are market-linked. However, if carefully invested in, debt schemes work out to be a better option than those we have discussed above. The following are the main features which makes it better than other options:

a)     Diversification: Mutual funds helps to diversify the investment even if it is as small as Rs. 5000. As a individual investor we can not buy may bonds/debentures with limited amount however mutual funds has the advantage to invest the pool of money in various securities. Hence, our risk too, will get diversified over multiple securities by investing in single scheme. But before investing in a debt mutual fund scheme, we should analyse the latest portfolio holdings to check whether the schemes are well-diversified and if they are invested in high credit rated assets.

b)     Liquidity: Most debt schemes have an exit load period of a few months to a year. Therefore, if we redeem our investment before this period, we will be charged an exit load or penalty. The exit load ranges from 0.25% to 1% depending on the scheme. This is similar to the premature penalty charged by banks on fixed deposits. But the exit load instils discipline in investments. Besides, most debt schemes are fairly liquid and able to meet redemption requests on a day-to-day basis. This is where debt schemes score over corporate FDs, which have a fixed lock-in period or tax-free bonds where we have to search for a buyer on the exchange.

c)     Benefit from falling yields: if interest rates continue to fall the net asset value of debt mutual fund scheme will move higher. Hence, we will earn higher returns on our investment. When yields fall, the price of a bond rises and vice versa hence the NAV of schemes goes up. If we see past one year’s performance those who invested one years back has go decent returns on account of the falling yields. The average return over the past year of higher maturity debt schemes, works out to around 9.5-10% which is much better than bank FDs. However we should also understand that, if yields go up, the bond price will fall and so will the NAV of the debt mutual fund scheme you invest.

In current time when there is space for accommodative policy (abetted by inflation), interest rates in the economy are expected to go downhill. Another 25-50 bps reduction cannot be ruled out in time to come if inflation data remains benign.

To manage very short-term liquidity needs, where the investment horizon is fairly short i.e. less than a 3 months, money can be parked money liquid funds vis-à-vis savings bank account. For short-term investment horizon of 3 to 6 months, ultra-short term funds and/or arbitrage funds can be considered for investments.

 

d)   Tax benefits: This is where debt funds score over bank FDs and other taxable interest bearing investments. The interest we earn on bank FDs is added to our income (under "income from other sources") and gets taxed as per our income tax slab, irrespective of your holding period, further tax is deducted on source (TDS) if interest income is more than 10,000/- in case of Bank FDs and Rs. 5000/- for Corporate FDs . However, in the case of debt schemes, if our holding period is three years or more, the gains are taxed at 20% with indexation. With the indexation benefit, post-tax return will work out to be far more tax efficient than in case of bank FDs. For any period less than three years, the gains will be added to the income and taxed accordingly. Before investing in a scheme, we should check if the yield is higher than the current bank FD rates, whether it has good quality of assets in the portfolio, and if its average maturity is equivalent to your investment horizon.

e)     Professional management: In Mutual funds, fund manager will manage the quality, diversification of securities and we don't need to worry about these things. Based on the investment objective of the scheme, the fund manager is expected to vary the investment accordingly. We can always select a scheme based on performance track record on a host of parameters, and also assess how the fund manager has done his job. If schemes under him have done well, we can expect the performance to continue. This professional management does come as a cost in the form of expense ratio or fees. Most debt schemes charge an expense ratio of around 1%. We should keep an eye on costs as well before selecting a debt scheme.

 Remember:

·      Although Bank FDs and Small Savings Schemes are safe and easy to manage, but in the current scenario the post-tax returns are not encouraging

·        In a falling interest rate environment, debt funds are expected to perform better than bank FDs.

·        Debt funds are more tax efficient as compared to bank FDs if held for a period of 3 years or more.