Rate cut: Impact on bonds and funds
Oct 30, 2001

Author: PersonalFN Content & Research Team

The Reserve Bank of India (RBI) has announced a reduction in bank rate by 50 basis points to 6.5% and 200 basis points cut in CRR to 5.5%. Lets assess the impact of these rate cuts on investments in deposits and mutual funds.

Impact on Fixed income instruments

Fixed deposits:
Industry sources expect the rate on fixed deposits (FDs) to be pulled down over the next few days. Companies like HDFC and Larsen & Toubro have already reduced their rate from 9% p.a. (for 1 year deposit) and 10% p.a. (for 3 years) to 8.6% and 9% p.a. respectively even before the RBI announced the rate cut. Similarly bank deposits are also expected to cut down their deposit rates from the prevailing 8-9% p.a for 1 year. Fixed deposits may loose their sheen after this rate cut, as apart from the lower returns the investor will have to pay tax if the interest income is over Rs 5,000, which makes it very unattractive.

RBI Relief Bonds:
RBI is also expected to cut the rate on its relief bonds from 8.5% p.a. to 8% p.a. However, even if there is a rate cut, RBI bonds will still remain an effective and attractive instrument for the retail investor due to its tax-efficiency and highest safety.

Impact on Mutual funds
Mutual funds especially the income (bond) and gilt fund category will be the major beneficiaries by the rate cut. Whenever there is a rate cut the yield on the bond paper falls as the interest rate falls however the price of the bond increases. As bond prices increase, the value of the portfolio increases and this pushes up the net asset value (NAV).

Looking at the current scenario of low interest rates, which are expected to continue for some time, investors need to consider several factors before investing. If they wish to combine returns with safety they should look at RBI Relief bonds, which are particularly attractive given the 8.5% coupon rate, which is on the higher side after the RBI rate cut. At this rate, the investor will lock his return for 5 years, even if the RBI reduces the relief bond coupon rate. However, investors need to take note of the fact that the Y.V. Reddy committee has given a recommendation of scraping these bonds.

However, if investors wish to combine liquidity with returns, then income/gilt funds are still the best option. Investors need to realise that while income funds may be safe, they may be exposed to interest rate risk, which could infuse some volatility in returns.

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