Brace for harsher interest rate cuts on small savings

Sanjay Kumar Singh, Economic Times, 1/4/2013


If you are disappointed by the recent cut in interest rates on small savings, get used to the feeling because a harsher cut is in store next year. This is because interest rates are linked to the yields of government securities in the previous calendar year.

The various small savings schemes offer interest rates that are 25-100 basis points more than the yield of government bonds with similar maturities. The mark-up varies from 100 bps for the Senior Citizen’s Savings Scheme (SCSS), 50 bps for the 10-year National Savings Certificate (NSC), and 25 bps for others, including the all-time favourite Public Provident Fund (PPF).

The government bond yields were high in the first quarter of 2012, but fell after the RBI cut interest rates. For instance, the yield of the 10-year bond spiked to 8.7% in April 2012, later dropped to 8.2%, and has stayed below 8% in the past three months.

The RBI has cut the repo rate by 50 bps this year, but there is no certainty if this trend will continue. At the policy review meeting on 19 March, the RBI governor indicated that there was little room for further cuts. The central bank is concerned about the divergence between the Wholesale Price Index (WPI), which has softened to 6.84%, and the Consumer Price Index (CPI), which remains stubbornly high at 10.91%.

Even if the central bank pauses for some time and there is no further policy action during the year, investors should brace themselves for harsher cuts next year. Assuming that the 10-year bond yield stays put at 8%, the rate for the 10-year NSC will be scaled down by 30 basis points from 8.8% to 8.5%. By the same assumption, the PPF rate could recede by almost 45 basis points to 8.25% in 2014-15.

The new interest rates announced for the NSC, SCSS and term deposits are only for fresh investments. In other words, you can lock in at the current rates and enjoy the same rates till maturity. However, this does not apply to the PPF and the new rate announced every year applies to new as well as existing investments.

Despite the rate cuts, small savings are good bets for risk-averse investors who want to put money in government-backed instruments. The 9.2% offered by SCSS is lower than that given to senior citizens by most banks. However, the quarterly payment of interest is useful for retirees. The tax-free status of the PPF still makes it an attractive option, especially for those in the high income bracket.

Says Veer Sardesai, chief executive of Pune-based financial planning firm, Sardesai Finance: "The lower interest rate offered by small savings instruments must be seen in the context of the zero risk they offer, since they are sovereign-backed instruments. Among them, the PPF remains the most attractive product." Before the interest rates were linked to G-sec yields in 2011, their PPF investment fetched a return of only 8%. It was raised to 8.6% in 2011-12, and then to 8.8% in 2012-13. The annual investment limit was also raised from Rs70,000 to Rs 1 lakh.

What should you do?
The risk-averse investors who want the safety of government-backed instruments have little choice but to grin and bear these cuts. However, those with a moderate or high risk appetite should use this occasion to build a diversified debt portfolio that earns them attractive risk-adjusted returns. Here’s how to do it.

Step one: Build a laddered debt portfolio. Says Vishal Dhawan of Mumbai-based financial planning firm, Plan Ahead Wealth Advisors: "The different instruments in your debt portfolio should mature at different points of time. If all do so at the same time, especially when rates are low, your portfolio will bear the brunt of reinvestment risk." In other words, all your funds will have to be reinvested at a low rate.

Step two: Have a blend of instruments with fixed and variable rates in your portfolio. "While fixed-rate instruments will allow you to lock into current rates and provide predictability to your portfolio, those with variable rates will enable you to take advantage of interest rate movements," advises Dhawan.

Step three: Look out for the launch of inflation-indexed bonds, as announced by the finance minister in the Budget. "If they are structured right, they are likely to become an important part of investors’ fixed-income portfolios in the future," says Dhawan.

Step four: Choose products based on your investment horizon. As this increases, your options go up. So, if you want to invest for 15 years, you could pick tax-free bonds of this duration, but you can also invest in equity. Despite the their short-term volatility, equity will give returns that beat inflation in the long run.

Step five: If your risk appetite permits, allocate a portion of your debt portfolio to mutual fund products, such as income funds and dynamic bond funds. They are not only tax-efficient, but if you hold them for more than one year, the capital gain is taxed at 10% without indexation and 20% with indexation. For investors in high tax bracket, this is better than being taxed at the marginal rate. Besides, you can invest in these instruments to take advantage of the likely decline in interest rates over the medium term.


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