Falling Interest Rate: Looking beyond Bank Fixed FDs

A recent repo rate 50 bps cut has different impact for different segments of investors. Corporates are welcomed because their cost of capital will come down and stock markets are cheered due to ease of their liquidity. Existing and potential home loan borrowers are also feeling a relief because it brings down their EMIs. At the same time, conservative investors who usually invest in bank fixed deposits are a worried lot because their returns are trimmed due to get down deposit rates. The worst hit is senior citizens and those in highest tax bracket (30.9%) who depends totally on interest from their fixed deposits and small savings. Indeed, there is no doubt in anyone’s mind that RBI has begun a rate cut cycle and interest rates are expected to decline further. Though the importance of bank FDs is not debatable, these have been become unattractive option from the perspective of returns for those who are in the highest tax bracket. Following the rate cut, bank interest rate on medium- to long-term deposits with maturity of one year to less than five years has also breached its psychological base interest rate 8% p.a. and hovering below it.  Now almost all PSUs and some private banks are offering   from 5% to 7.75% p.a., and bank FD is no longer an attractive proposition. Amid the volatility of interest rate cycle, not many people realize that there are other better options than bank fixed deposits. If so, which fixed-income products would be best suited for you? Read the fine print and check your suitability.

Tax-free Bonds

In a declining rate regime, tax-free bonds have opened new door to have an opportunity to earn higher interest than banks FDs. Since bank FD interest is very much taxable in the hands of investor, so who is in the highest tax bracket (30.9%), will get effectively return only 5.35% p.a., if one earns current bank FD rate 7.75% p.a.  The recent issue Power Finance Corporation (PFC) bonds offered 7.60% on the 20-year bond. Since the interest earned on these bonds is non-taxable, will translate its pretax yield at 11%p.a., higher than what bank deposits give in the highest 30.9% tax bracket. However, before investing, one needs to check whether such products are the right avenues for their long-term goals. It’s a contrarian approach for long-term investing.

            Since these tax-free bonds are long-term instruments with tenures of 10-20 years, the value of the bonds will fluctuate with respect to the interest rate, it may not be the best option for short-term investment. However, if you are intent to hold the bonds for the full term, the fluctuations in interest rates should not bother you and would still give you yield around 7% tax-free. You may consider buying if you are satisfied with earning YTM 7% p.a. for long-term investment for which you should hold the bonds till maturity. Though tax-free bonds are illiquid in short-term, there is an opportunity to make capital gain or loss over period of one year while selling these bonds in secondary market and will attract capital gain tax. But you cannot buy and sell anytime and any amount due to low-trading volumes. Given these yields, such bonds may make sense for investors in the higher tax brackets only. Other investors, in the nil / low tax brackets may stick with their all-time favourite bank fixed-deposits (FDs) and   could earn better post-tax returns.

Small Saving Schemes

Though small saving schemes like PPF, NSC, Senior Citizen Savings Scheme as well as the Sukanya Samriddhi Yojana for the girl child could not be an alternate to bank FDs, these have also enjoyed tax-free advantage as well as deductible under section 80C that offer higher returns over bank FDs certainly for those in higher tax brackets. Generally, the rates on small savings schemes are linked to the yields of government bonds of the same tenure and are usually revised once a year around March-April. If you are planning to invest in these schemes, you should invest today as the government is considering revising the rates more frequently. However, there are caps on the amount you can invest in some of these schemes. You cannot put more than Rs 1.5 lakh a year in your PPF account. This limit applies even if you have opened an account in the name of a minor child. The combined limit is still Rs 1.5 lakh. Likewise, the Sukanya Samriddhi Yojana also has a Rs 1 lakh annual investment limit. If you have opened accounts in the name of two daughters, the combined investment limit remains Rs 1.5 lakh. However, you must be mentally prepared to see small savings rates being cut in future. While considering too much debt portfolio may hamper the growth of your investment.

Company Fixed Deposits

Company or corporate fixed deposits also offer higher fixed interest of income than bank fixed deposit, even after bank FD rates have been cut by 50bps to 100bps in the past six months. Although corporate FDs fetch higher rates than bank FDs, they are considered as unsecure and can expose you to the risk of losing your principal if you don’t check the credibility and rating of the company. While considering corporate FDs, you should consider FDs of non-banking finance companies (NBFC) with the highest rating AA and above. Like bank FDs, its interest is also very much fully taxable as per your tax bracket, but they may still give more post-tax returns over the bank FDs due to offering higher interest than bank FDs.  However, premature withdrawal of company FD is virtually impossible. Hence, tax-free bonds are more secure than company FDs and should be a better option.

Debt Mutual Funds

Another category of fixed income products is debt mutual funds that may provide you steady returns and put them in debt securities, most of which are market-linked. Debt schemes can be divided into two main categories long-term debt schemes and short-term debt schemes, depending on the average maturity, or duration, of the securities. There is a possibility of capital erosion when interest rates go up.  Therefore, the net asset value (NAV) of a debt scheme can go up and down, depending on the trends in interest rates. But not all debt investments go down by the same extent. The longer the maturity of a debt, the more sensitive its returns are to interest rate changes and the higher will be the impact on its NAV. For most savers whose investment horizon may exceed three years, open-ended debt schemes may be the best bet, despite they lost the indexation tax benefits for one to three years.  Bank FDs are not still appreared a better option for those investors who are already familiar with debt schemes.

Investing in debt mutual fund growth option can help you defer your tax liability in case you don’t redeem any units. Until there is redemption of units, you have no tax liability, which is opposite to a bank FD wherein tax liability will arise even for accrued interest on cumulative FDs. You may not get income until the cumulative FD matures, but you have to pay the tax on accrued interest every year. Moreover, if you hold the banking debt MF scheme for a longer period, the effective tax liability using ’indexation’ can be near zero when you redeem your units. The tax handling is much easier in this option. If your tax liability on mutual fund units’ redemption is near-zero or zero, you will not be stressed at the time of tax filing. You just have to calculate using ‘indexation’.

Investors in debt schemes can not only invest regularly via a systematic investment plan (SIP), they can withdraw whenever they need to, without being subject to a lock-in period. Capital gains will be taxed with the indexation benefit for investments longer than three years.

Fixed Maturity Plans(FMPs)

Fixed maturity plans (FMPs) are being considered as an alternative to bank FDs. These have distinct tax advantages over bank FDs certainly for those in higher tax brackets; but FMPs cannot beat bank FDs in transparency, safety, returns and liquidity, in case of premature withdrawal. FMPs don’t offer guaranteed returns; only a fixed maturity term. They don’t have to declare mark-to-market losses as they hold the investments till maturity. Therefore, investors don’t suffer the volatility in returns seen in a typical bond or income scheme. Those in the 20%-30% tax bracket can invest some part of their debt portfolio in ‘low risk’-rated FMPs with a good mutual fund house. The reason to consider this asset class is that their post-tax returns can even beat the returns on tax-free bonds. However, there is no guarantee that FMP returns will be close to your calculations and, hence, there is an inherent risk in the product.

 You may end up not just paying zero tax, but even generating long-term capital loss on paper, which can be set off against other long-term capital gains, reducing your tax liability further. Indexation benefit of tax treatment offers compensation against rising inflation. It is a technique to adjust income payments by means of a price index.

Liquid and Ultra –Short Term Fund (UST)

Last but by no means least, there is a category of mutual funds called liquid funds and ultra-short-term (UST) schemes which are equally attractive. Liquid as well as UST schemes have fetched average returns of over 9%, and highest return of nearly 10%, in FY13-14. They have outperformed all other debt scheme options and, hence, offer an exciting option for investors.  Investors in the tax bracket of 20% or more should make efforts to invest in liquid or UST schemes instead of leaving surpluses in savings accounts earning 4% to 6%pa. Investors in bank fixed deposits also need to take a hard look at liquid or UST schemes due to tax efficiency, if they stay invested for more than one year. Many short-term FD investors keep rolling the FD after maturity and, hence, easily complete more than one year. If you had kept the funds in liquid or UST schemes, you would have got better returns due to indexation feature available for ‘growth’ option, after completing one year. Those in the tax bracket of upto 10% should continue with bank FD, as there is not much benefit in shifting to debt funds.

Conclusion

Indeed, when it comes to choosing debt portfolio, some choices narrow down to liquid, some thumb up for tax free and some appears volatility.  Most investors dislike volatility and know nothing about interest rate cycles. They might be bewildered by the volatility of income or long-term debt schemes when interest rates turn volatile, as happened last year. They would do well to stick with a balanced debt instruments. Even short-term schemes have fetched negative returns sometimes on portfolio durations of one to three years. Liquid and UST schemes are the ultimate answer to the investor who is happy with getting returns in line with short-term market interest rates and is looking for a better option than bank FDs.

This article got published in Hindi Version at Dainik Bhaskar Edition on 24-11-2015

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