As Bank FD Rates Fall, Here Are Your Options To Invest…   Oct 27, 2016

Over the past 22 months, through a series of rate cuts, the Reserve Bank of India (RBI) reduced benchmark policy rate by 175 basis points (bps) to 6.25%. As a result, the interest rate offered by bank fixed deposits and Small Saving Schemes viz. Public Provident Fund (PPF), postal savings schemes too, have reduced – disappointing many looking to earn fixed returns.

A few years ago, you would have earned an interest rate in the range of 8.00%-9.00% on a 1-year term deposit; but now have to settle for far less – anywhere in the range of 6.00%-7.50%.

The Rise and Fall of Bank FD Rates

(Source: RBI, PersonalFN Research)

The impact of falling interest rates…

If we work out the numbers, you would earn annual interest of Rs 93,083 (quarterly compounding) with a bank FD commanding an interest rate of 9.00%. But with the current FD rates hovering around 7.25%, your yearly return on fresh deposits will be approximately Rs75,000 – nearly Rs20,000 lower… and mind you, this is excluding tax.

If you're placed in the highest tax bracket, the net yield from the bank FD will fall to a paltry 4.87%. And further, if you account for inflation – hovering on an average 5% over the past year – your real rate of return (also known also as inflation-adjusted return) on your investment would be -0.13%.

Senior citizens, who depend on interest income to fund day-to-day expenses, would certainly be worried.

Hence, in such a scenario it would be imperative and prudent to look at alternative investment avenues, while we recognise that many of you perceive bank fixed deposits or SSS to be safe and easy to manage. Yes, there is no dearth of fixed income products available. The risk and reward will vary depending on the option you choose.

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.

Corporate fixed deposits and corporate bonds: Corporate FDs and bonds earn you a higher interest than bank FDs. However, as we mentioned earlier, the higher yield comes with a higher risk. The risk of default in corporate FDs cannot be ignored. Those of you who invested your hard-earned money in deposits of companies such as Helios and Matheson, Jaiprakash Associates or those of the Yash Birla group will relate to the alarming incident. Depositors in companies such as these are fighting a losing battle to recover the interest and, in some cases, even their principal. Due to the poor regulatory framework, there is little respite if the company fails to earn back your hard-earned money.

Tax-free Bonds: Tax-free bonds are a good long-term fixed income option, especially if you are 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. You can even buy and sell these bonds in the secondary market; however, liquidity can be an issue. If you choose to sell the bond before its maturity and if there are no buyers on the exchange, liquidity will be found wanting. Currently, there are no tax-free bonds available for subscription in the primary market, but as the financial year draws to a close, you may find quite a few in the offing. In the secondary market, the bonds are trading at a yield of around 6.19%. The returns of course 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.

Debt mutual funds: This brings us to debt mutual funds. Debt funds work out to be a better option than those we have discussed above. Based on the fund investment mandate, debt funds invest in different securities such as government bonds, corporate bonds, corporate deposits, etc. with different maturities. Note this, 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 bank fixed deposits. We give you 5 reasons why debt mutual fund schemes work as a part of your fixed income portfolio.

  1. Diversification: Diversification across different securities will prove to be suboptimal if you are looking to invest as an individual. For example, if you have Rs 50,000 to invest, you may be unable to spread your investment over a wide range of high yielding fixed income products. And even if you are able to, you may need to maintain several different accounts, which can become extremely cumbersome. However, if you invest through debt schemes, your investment will be divided over a wide range of securities. Hence, your risk too, will get diversified over multiple securities by investing in single scheme. But before investing in a debt mutual fund scheme, you need to view its latest portfolio holdings to check whether the schemes are well-diversified and if they are invested in high credit rated assets.
  2. Benefit from falling yields: When yields fall, the price of a bond rises and vice versa. Therefore, if yields continue to fall the net asset value of your scheme will move higher. Hence, you will earn higher returns on your investment. Those of you who invested over the past year or so, would have benefitted the most from the falling yields – especially had the portfolio been skewed towards longer maturity papers. The median return over the past year of higher maturity debt schemes, works out to around 10% as on October 20, 2016 – which is clearly much better than bank FDs. Having said that, you need to be aware that if yields go up, the bond price will fall and so will the NAV of the debt mutual fund scheme you invest.

    In a time when space for accommodative policy action has opened up (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. But what's noteworthy is, most part of the rally has already been captured ahead of the accommodative stance RBI has taken, and thus pressure seems to have lessened. Therefore, it would not be wise to go overboard while investing at the longer end; refrain from investing more than 20% of your allocation in long-term debt funds . We suggest, consider dynamic bond funds (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) while taking exposure at the longer end, provided you have an investment horizon of at least 3 years.

    To manage short-term liquidity needs, where the investment horizon is fairly short i.e. less than a year, you may park money in a savings bank account, liquid funds and/or arbitrage funds, stay away from debt funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds.
  3. Tax benefits: This is where debt funds score over bank FDs and other taxable interest bearing investments. The interest you earn on bank FDs is added to your income (under "income from other sources") and gets taxed as per your income tax slab, irrespective of your holding period. However, in the case of debt schemes, if you hold your units for three years or more, the gains are taxed at 20% with indexation. With the indexation benefit, for a top performing debt scheme, your 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 your income and taxed accordingly. Therefore, before investing in a scheme, 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.
  4. Liquidity: Most debt schemes have an exit load period of a few months to a year. Therefore, if you redeem your investment before this period, you 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 as you invest. 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 you need to search for a buyer on the exchange.
  5. Professional management: You don't need to worry on how to best diversify your investment over a range of securities. Your fund manager will do that for you. Based on the investment objective of the scheme, the fund manager is expected to vary the investment accordingly. You 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, you 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%. Do keep an eye on costs as well before selecting a debt scheme.

Of course, not all debt schemes will be worthy of your investment. You need to choose wisely. You can also avail of PersonalFN's DebtSelect service that will choose the best debt mutual funds for your investment portfolio.

Don't get swayed by distributors, relationship managers, or wealth managers who push hybrid schemes such as Monthly Income Plans (MIPS) or Equity Savings Schemes (ESSs), or balanced funds as alternatives. These schemes introduce an equity component for "wealth creation" – which may be unsuitable if you were to evaluate investment avenues against bank FDs, due to the high risk involved. While you invest, ascertain your risk profile prudently so as to have suitable investment avenues in your portfolio.

Key takeaways…

  • Bank FDs and Small Savings Schemes are safe and easy to manage, but 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 enjoy a tax advantage as compared to bank FDs if held for a period of 3 years or more
  • Stay away from debt funds with longer maturities and those with investments in low-rated securities

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