Living with lower interest rates
The interest rates on small savings schemes, a favourite among Indian household investors, have dropped to a multi-decade low. For example, interest on the ever- popular Public Provident Fund (PPF) is down to 7.6 per cent (January 2018) and on the Senior Citizen Savings Scheme to 8.3 per cent. The rate cuts have left in the lurch all those risk-averse investors, who swore by investments like the PPF which carry a government guarantee.
Why have interest rates come down
Interest rates on small savings schemes (SSS) are now market-linked and formulae driven. They were linked to government bond yields in 2011 but were revised once a year. Since April 2016, the reset in interest rates has been done quarterly based on the average yield on government bonds of similar maturity in the previous quarter with the government paying a mark-up on this. The mark-up on PPF is 25 basis points (100 basis points is equal to 1 per cent). The formula is meant to align all interest rates in the economy. The fall in yield of government papers after the cut in repo rates by the Reserve Bank of India (RBI) has led the government to cut interest rates on small savings schemes.
Ladder 7 Financial Advisories founder Suresh Sadagopan says, "The government has been cutting interest rates to align small savings schemes to the overall interest rate scenario. It may not want to pay more than market rates as it increases its liability."
Lovaii Navlakhi, MD and CEO, International Money Matters, says, "With falling inflation, the government decided to link rates on small savings schemes to inflation and policy rates. Otherwise, you would have a situation today where investors receive 4-5 per cent real returns on a low risk investment." Being formulae driven also means that the rates on small savings will go up as and when yields go up-they have started to rise towards the end of 2017. So, it may be possible that the government will not cut interest rates further.
Shift towards risky assets
Falling interest rates and the simultaneous buoyancy in the equity market have nudged people towards equity investments, which the risk-averse investor is uncomfortable with as an asset class. "It may not be the government's intention to drive people towards mutual funds... but it's happening alright," says Sadagopan.
Equity mutual funds have received a massive inflow of Rs 1.27 lakh crore in the past two financial years, as per Centre for Monitoring Indian Economy (CMIE) data. There have been reports of mis-selling of balanced funds to retired individuals promising them assured dividend whereas neither dividend nor returns are guaranteed in case of MFs. Balanced funds have had inflows of Rs 50,000 crore over the past two years.
Investors need to be alert, suggest experts. "While equities are a great long-term asset class, do not base investment decisions on past returns alone, as they may or may not get repeated, especially in the short run," says Kaustubh Belapurkar, Director, Fund Research, Morningstar India. "Instead, understand your risk return expectations, investment time horizon and liquidity requirements and then choose the right asset allocation for your portfolio."
Look at the real rate of return
Though interest rates have dropped in absolute terms, inflation too has come down, so the real rate of returns is higher compared to 3-4 years ago. "In 2014, inflation was around 8 per cent and small savings products were offering returns ranging between 8.4 and 8.7 per cent. As of FY17, with inflation averaging 5.5 per cent, small savings are offering 7.4-7.6 per cent interest. Inflation today is lower when compared historically resulting in higher real returns today," says Navlakhi.
Options for small savers
Fixed income investors looking for alternatives can consider these options.
Voluntary Provident Fund: Most of the salaried class contributes 12 per cent of the salary towards Employees' Provident Fund (EPF). A matching contribution is made by the employer. The interest rate on EPF is revised annually and is 8.65 per cent currently. So, those who want to make a higher contribution can invest through voluntary provident fund (VPF). The interest earned as well as the accumulation is tax free on withdrawal. "The VPF is an attractive option for investors considering the rates are substantially higher than other fixed income rates," says Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors.
Government bonds: The government has stopped the 8 per cent savings bonds scheme, and launched 7.75 per cent bonds instead. In case of falling interest rates, these can be an alternative for investors, especially those in lower tax brackets. The interest earned, though, will be taxable. One can invest a minimum of Rs 1,000 while there is no upper limit. The bonds have a maturity of seven years.
Bank fixed deposits: After demonetisation, banks had to slash deposit rates due to influx of liquidity. Currently, five-year deposits are offering interest of around 6.25 to 6.5 per cent. Investors should also remember that interest earned is taxable.
Debt mutual funds: Those amenable to a slight risk can consider debt funds. "Debt mutual funds do give better inflation adjusted returns ," says Navlakhi. "But picking the right fund is crucial. Conservative investors can look at funds which invest only in quality debt papers and slightly aggressive investors can explore corporate bond funds or equity savings category of MFs."
What the budget can do for small savers
With the lower absolute returns today, people are expecting tax breaks from the government. Instruments such as the PPF get it under Section 80C. The government could either increase the overall deduction limit under Section 80C or consider a preferential tax dispensation for long-term retirement savings products such as the PPF.
"Currently, the options under Section 80C are either debt products with long lock-in periods or the other extreme, the riskier ELSS with a three-year lock-in. The government could consider an investment option such as debt or hybrid-linked saving schemes for conservative investors who do not want to lock in funds in PPF or the National Pension System. Also increasing 80C from the current Rs 1.5 lakh limit is something the government can do for small investors," says Navlakhi.
The government can also bring back infrastructure bonds. "It can consider the issuance of infrastructure bonds with a long tenure that will enable investors to reduce reinvestment risk on their fixed income portfolios, and also enable the government to have access to long term funds," says Dhawan. "These may need to offer a 2 per cent per annum higher return than long term deposits so that investors are compensated for locking in their money for a longer tenure. Some tax benefits on maturity or interest payouts may also be considered."
Why have interest rates come down
Interest rates on small savings schemes (SSS) are now market-linked and formulae driven. They were linked to government bond yields in 2011 but were revised once a year. Since April 2016, the reset in interest rates has been done quarterly based on the average yield on government bonds of similar maturity in the previous quarter with the government paying a mark-up on this. The mark-up on PPF is 25 basis points (100 basis points is equal to 1 per cent). The formula is meant to align all interest rates in the economy. The fall in yield of government papers after the cut in repo rates by the Reserve Bank of India (RBI) has led the government to cut interest rates on small savings schemes.
Lovaii Navlakhi, MD and CEO, International Money Matters, says, "With falling inflation, the government decided to link rates on small savings schemes to inflation and policy rates. Otherwise, you would have a situation today where investors receive 4-5 per cent real returns on a low risk investment." Being formulae driven also means that the rates on small savings will go up as and when yields go up-they have started to rise towards the end of 2017. So, it may be possible that the government will not cut interest rates further.
Shift towards risky assets
Falling interest rates and the simultaneous buoyancy in the equity market have nudged people towards equity investments, which the risk-averse investor is uncomfortable with as an asset class. "It may not be the government's intention to drive people towards mutual funds... but it's happening alright," says Sadagopan.
Equity mutual funds have received a massive inflow of Rs 1.27 lakh crore in the past two financial years, as per Centre for Monitoring Indian Economy (CMIE) data. There have been reports of mis-selling of balanced funds to retired individuals promising them assured dividend whereas neither dividend nor returns are guaranteed in case of MFs. Balanced funds have had inflows of Rs 50,000 crore over the past two years.
Investors need to be alert, suggest experts. "While equities are a great long-term asset class, do not base investment decisions on past returns alone, as they may or may not get repeated, especially in the short run," says Kaustubh Belapurkar, Director, Fund Research, Morningstar India. "Instead, understand your risk return expectations, investment time horizon and liquidity requirements and then choose the right asset allocation for your portfolio."
Look at the real rate of return
Though interest rates have dropped in absolute terms, inflation too has come down, so the real rate of returns is higher compared to 3-4 years ago. "In 2014, inflation was around 8 per cent and small savings products were offering returns ranging between 8.4 and 8.7 per cent. As of FY17, with inflation averaging 5.5 per cent, small savings are offering 7.4-7.6 per cent interest. Inflation today is lower when compared historically resulting in higher real returns today," says Navlakhi.
Options for small savers
Fixed income investors looking for alternatives can consider these options.
Voluntary Provident Fund: Most of the salaried class contributes 12 per cent of the salary towards Employees' Provident Fund (EPF). A matching contribution is made by the employer. The interest rate on EPF is revised annually and is 8.65 per cent currently. So, those who want to make a higher contribution can invest through voluntary provident fund (VPF). The interest earned as well as the accumulation is tax free on withdrawal. "The VPF is an attractive option for investors considering the rates are substantially higher than other fixed income rates," says Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors.
Government bonds: The government has stopped the 8 per cent savings bonds scheme, and launched 7.75 per cent bonds instead. In case of falling interest rates, these can be an alternative for investors, especially those in lower tax brackets. The interest earned, though, will be taxable. One can invest a minimum of Rs 1,000 while there is no upper limit. The bonds have a maturity of seven years.
Bank fixed deposits: After demonetisation, banks had to slash deposit rates due to influx of liquidity. Currently, five-year deposits are offering interest of around 6.25 to 6.5 per cent. Investors should also remember that interest earned is taxable.
Debt mutual funds: Those amenable to a slight risk can consider debt funds. "Debt mutual funds do give better inflation adjusted returns ," says Navlakhi. "But picking the right fund is crucial. Conservative investors can look at funds which invest only in quality debt papers and slightly aggressive investors can explore corporate bond funds or equity savings category of MFs."
What the budget can do for small savers
With the lower absolute returns today, people are expecting tax breaks from the government. Instruments such as the PPF get it under Section 80C. The government could either increase the overall deduction limit under Section 80C or consider a preferential tax dispensation for long-term retirement savings products such as the PPF.
"Currently, the options under Section 80C are either debt products with long lock-in periods or the other extreme, the riskier ELSS with a three-year lock-in. The government could consider an investment option such as debt or hybrid-linked saving schemes for conservative investors who do not want to lock in funds in PPF or the National Pension System. Also increasing 80C from the current Rs 1.5 lakh limit is something the government can do for small investors," says Navlakhi.
The government can also bring back infrastructure bonds. "It can consider the issuance of infrastructure bonds with a long tenure that will enable investors to reduce reinvestment risk on their fixed income portfolios, and also enable the government to have access to long term funds," says Dhawan. "These may need to offer a 2 per cent per annum higher return than long term deposits so that investors are compensated for locking in their money for a longer tenure. Some tax benefits on maturity or interest payouts may also be considered."
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