Gain fall in from interest rates
Interest
rates are set to come down this year. While it’s good news for borrowers,
investors can also benefit by using these smart strategies.
If there is
one thing that investors, businessmen and consumers want right now, it is a cut
in interest rates. When RBI governor D Subbarao unveils the monetary policy on
29 January, it is likely that he will oblige the teeming masses. In fact, a
rate cut is almost a foregone conclusion, though the quantum of the rate cut is
still a subject of intense speculation. Till about a fortnight ago, there were
rumours that easing inflation will nudge the RBI to affect a cut of 50 basis
points. Some were optimistic that rates will be cut by 100 basis points.
However, the expectations were later revised to a 25 basis point reduction.
How will a rate cut affect you as an investor and a borrower? ET Wealthreached out to experts to analyse how lower interest rates will impact your investments. We analysed the products and sectors that will benefit if rates are eased. Which companies are best placed to gain from a benign rate structure? We also looked at the strategy you should adopt at this juncture, both as an investor and a borrower.
For now, a large section of the investor community has already priced in the rate cut. Over the past few weeks, the yield of the benchmark 10-year government bond has dropped significantly (see chart), reflecting the change in sentiment. Is this optimism justified? Some experts reckon that the stage is set for a decisive move from the central bank. Inflation is now within touching distance of the RBI’s stated comfort zone of around 7%. The government has also taken steps to manage the fiscal situation. Rahul Goswami, CIO, fixed income, ICICI Prudential AMC, expects the RBI to cut rates by 50-75 basis points over the next three months. The 10-year bond yield is likely to be in the 7.55-8.15% range during this period. Says Amit Tripathi, head, fixed income, Reliance Capital Asset Management: “Rates could be cut by 50 basis points over the next three months. Further action by the RBI will depend on how macro data pans out. It is likely to come down by 75-100 basis points over the next 12 months.”
However, others believe the RBI will take a measured approach. A big rate cut at this juncture could cause inflation to flare up again. Experts say wholesale price inflation has come off, but the RBI could take the high consumer price inflation into account before embarking on a rate reversal. Says Indranil Pan, chief economist, Kotak Mahindra Bank: “We think that the RBI would be mindful of the CPI dynamics and also the risks to the economy from a continuing high current account deficit and loose fiscal. We continue to highlight a calibrated and cautious easing stance from the RBI and look forward to a 100 bps cumulative cut in the repo rate in 2013.”
Your investment strategy
Interest rates are cyclical and don’t remain stagnant for long, especially in a growing economy like India. The start of monetary easing provides investors not only an opportunity to lock in at high yields before rates are cut, but also enjoy capital gains from the resulting rally in bonds (see chart). Raghvendra Nath, managing director, Ladderup Wealth Management, says, “If the rate cycle turns as expected, a similar opportunity may not come by for years.”
Of course, your investment decisions should be guided not only by the expected return but also by your needs for regular income, safety of capital and liquidity. A bank deposit or a government-backed instrument, such as the PPF or NSC, is very safe. But a debt fund offers greater liquidity—you can withdraw the money at short notice. The tax efficiency of the instruments is also important. See how your choices measure up on these parameters before you invest. Debt funds are not very popular with retail investors because they don’t offer assured returns. Yet, given the impending cut in interest rates, these funds may be the best option for small investors today. They can earn you a higher return than a bank FD. Although bond yields have dropped significantly in recent weeks, experts believe there is still scope for a rally in bond prices. Says Tripathi: “A further softening of bond yields is expected, which gives enough leg-room for the rally to continue.”
Debt funds are also tax-efficient. The long-term capital gains tax is only 10% if you hold for more than a year. The tax could be even lower if you opt for the indexation benefit, which adjusts for inflation during the holding period. Vivek Rege, financial planner, VR Wealth Advisors, suggests, “Investors should take the debt fund route. These are not only tax-efficient, but also provide high liquidity.”
Long-term debt funds: Within bond funds, long-term debt funds (also known as duration funds) are a more attractive proposition. If interest rates come down, these funds will witness a more pronounced capital appreciation . These funds are more sensitive to fluctuations in rate movements than short-term funds. “This scenario provides an ideal opportunity to invest in duration products such as income funds and gilt funds,” says Sujoy Ghosh, head of fixed income, Religare Mutual Fund.
Gilt funds: If the reversal plays out as expected, gilt funds are likely to offer the best rewards. These schemes invest in government securities (or gilts) and, therefore, have very high-quality portfolios. As mentioned earlier, the yields of long-term government bonds have softened, which bodes well for long- and medium-term gilt funds. Aided by the rally in bond prices, gilt funds have managed to deliver double-digit returns over the past year. Most of these funds have been steadily increasing the average maturity of their holdings in tune with the falling bond yields. Between 2001 and 2008, when interest rates were slashed aggressively, these funds delivered as high as 25% annualised returns. But don’t expect history to repeat itself.
The only risk that you face with these funds is a heightened sensitivity to interest rate movement. If, for some reason, the expected cuts don’t happen or not to the anticipated extent, government bonds could lose value and investors in gilt funds could lose money. Rege says, “Gilt funds best capture any downward movement in interest rates, but they are also very volatile.” Income and dynamic bond funds: A safer bet are income funds, especially dynamic bond funds, which can quickly increase or decrease the maturity profile of their portfolio based on the interest rate outlook. They also invest across a variety of debt instruments, such as corporate bonds and fixed deposits, apart from government securities. This diversification also helps an income fund to provide more stable returns, says Nath. Income funds have been the best performing debt funds in the past year (see table) because they had increased their portfolio maturities in the past few months.
Tax-free bonds: During the past year, a number of tax-free bond issues have hit the market. These do not offer any tax deduction to investors, but the interest is tax-free, which makes them very attractive for those in the higher tax slabs of 20-30%. While the coupon rate of 8% is lower than that offered by bank fixed deposits, the post-tax yield is much higher. The income from a fixed deposit is fully taxable. The post-tax returns from a fixed deposit that offers 9% is only 6.3% for someone with an annual income of over 10 lakh. For those earning 5-10 lakh a year, the 20% tax will pare the yield of the fixed deposit to 7.2%. Keep in mind that the tax is payable on an accrual basis every year even if you have opted for the cumulative option.
The government had allowed state-owned infrastructure companies to raise up to 60,000 crore from the Indian public during 2012-13. However, so far only a fraction of this amount has been raised through tax-free bonds from companies like Power Finance Corporation, Hudco, India Infrastructure Finance Co, National Highway Authority of India and the IRFC. One such issue from IRFC closes on 29 January. If you missed this bus, consider other forthcoming issues before 31 March. This may effectively be your last chance to lock in at the existing high rates. Indications are that the Budget may not allow state-owned firms to float tax-free bonds.
Most of the tax-free bonds have high credit rating, which means the risk of default is very low. The tenure of these bonds is 10-15 years, so it gives investors an opportunity to lock in for a fairly long period. The best part is that these can be traded in the secondary debt market. You can cash out after a few years. If interest rates are down by then, you will pocket a neat sum in capital gains as well. “Tax-free bonds are ideal for investors in the high tax bracket. They provide enough liquidity and have no reinvestment risk,” says Nath.
Fixed deposits: For those in the lower income brackets, bank and corporate deposits are a better option. Banks and companies are offering attractive rates on fixed deposits, but this could change in the next few months. The deposit rates have already started moving south. Don’t be lured by very high rates of short-term deposits. A 6-9 month deposit could offer you up to 9.5%, but there is a very high reinvestment risk. When the deposit matures, you will not be able to reinvest the proceeds at a high rate. Given that the RBI is likely to ease rates further, the prevailing rate 6-9 months from now may be in the region of 7-8%. It’s best to opt for a longer duration so that you can benefit from the high rates for the rest of the tenure. However, only a few banks offer fixed deposit tenures of 8-10 years.
The deal is sweeter for senior citizens, who get 0.25-0.75% higher interest on their deposits. Some companies, such as housing finance major HDFC, offer their customers an additional 0.25% interest on deposits.
Recurring deposits: If you don’t have a large sum to put away in a fixed deposit immediately, consider starting a recurring deposit, where you invest a fixed sum every month. Once you start a recurring deposit, the rate remains uniform for the rest of the tenure. However, unlike fixed deposits, you can’t just walk into any bank and open a recurring deposit. Banks insist that you have a savings bank account with them from which a fixed amount will move to the recurring deposit every month.
How will a rate cut affect you as an investor and a borrower? ET Wealthreached out to experts to analyse how lower interest rates will impact your investments. We analysed the products and sectors that will benefit if rates are eased. Which companies are best placed to gain from a benign rate structure? We also looked at the strategy you should adopt at this juncture, both as an investor and a borrower.
For now, a large section of the investor community has already priced in the rate cut. Over the past few weeks, the yield of the benchmark 10-year government bond has dropped significantly (see chart), reflecting the change in sentiment. Is this optimism justified? Some experts reckon that the stage is set for a decisive move from the central bank. Inflation is now within touching distance of the RBI’s stated comfort zone of around 7%. The government has also taken steps to manage the fiscal situation. Rahul Goswami, CIO, fixed income, ICICI Prudential AMC, expects the RBI to cut rates by 50-75 basis points over the next three months. The 10-year bond yield is likely to be in the 7.55-8.15% range during this period. Says Amit Tripathi, head, fixed income, Reliance Capital Asset Management: “Rates could be cut by 50 basis points over the next three months. Further action by the RBI will depend on how macro data pans out. It is likely to come down by 75-100 basis points over the next 12 months.”
However, others believe the RBI will take a measured approach. A big rate cut at this juncture could cause inflation to flare up again. Experts say wholesale price inflation has come off, but the RBI could take the high consumer price inflation into account before embarking on a rate reversal. Says Indranil Pan, chief economist, Kotak Mahindra Bank: “We think that the RBI would be mindful of the CPI dynamics and also the risks to the economy from a continuing high current account deficit and loose fiscal. We continue to highlight a calibrated and cautious easing stance from the RBI and look forward to a 100 bps cumulative cut in the repo rate in 2013.”
Your investment strategy
Interest rates are cyclical and don’t remain stagnant for long, especially in a growing economy like India. The start of monetary easing provides investors not only an opportunity to lock in at high yields before rates are cut, but also enjoy capital gains from the resulting rally in bonds (see chart). Raghvendra Nath, managing director, Ladderup Wealth Management, says, “If the rate cycle turns as expected, a similar opportunity may not come by for years.”
Of course, your investment decisions should be guided not only by the expected return but also by your needs for regular income, safety of capital and liquidity. A bank deposit or a government-backed instrument, such as the PPF or NSC, is very safe. But a debt fund offers greater liquidity—you can withdraw the money at short notice. The tax efficiency of the instruments is also important. See how your choices measure up on these parameters before you invest. Debt funds are not very popular with retail investors because they don’t offer assured returns. Yet, given the impending cut in interest rates, these funds may be the best option for small investors today. They can earn you a higher return than a bank FD. Although bond yields have dropped significantly in recent weeks, experts believe there is still scope for a rally in bond prices. Says Tripathi: “A further softening of bond yields is expected, which gives enough leg-room for the rally to continue.”
Debt funds are also tax-efficient. The long-term capital gains tax is only 10% if you hold for more than a year. The tax could be even lower if you opt for the indexation benefit, which adjusts for inflation during the holding period. Vivek Rege, financial planner, VR Wealth Advisors, suggests, “Investors should take the debt fund route. These are not only tax-efficient, but also provide high liquidity.”
Long-term debt funds: Within bond funds, long-term debt funds (also known as duration funds) are a more attractive proposition. If interest rates come down, these funds will witness a more pronounced capital appreciation . These funds are more sensitive to fluctuations in rate movements than short-term funds. “This scenario provides an ideal opportunity to invest in duration products such as income funds and gilt funds,” says Sujoy Ghosh, head of fixed income, Religare Mutual Fund.
Gilt funds: If the reversal plays out as expected, gilt funds are likely to offer the best rewards. These schemes invest in government securities (or gilts) and, therefore, have very high-quality portfolios. As mentioned earlier, the yields of long-term government bonds have softened, which bodes well for long- and medium-term gilt funds. Aided by the rally in bond prices, gilt funds have managed to deliver double-digit returns over the past year. Most of these funds have been steadily increasing the average maturity of their holdings in tune with the falling bond yields. Between 2001 and 2008, when interest rates were slashed aggressively, these funds delivered as high as 25% annualised returns. But don’t expect history to repeat itself.
The only risk that you face with these funds is a heightened sensitivity to interest rate movement. If, for some reason, the expected cuts don’t happen or not to the anticipated extent, government bonds could lose value and investors in gilt funds could lose money. Rege says, “Gilt funds best capture any downward movement in interest rates, but they are also very volatile.” Income and dynamic bond funds: A safer bet are income funds, especially dynamic bond funds, which can quickly increase or decrease the maturity profile of their portfolio based on the interest rate outlook. They also invest across a variety of debt instruments, such as corporate bonds and fixed deposits, apart from government securities. This diversification also helps an income fund to provide more stable returns, says Nath. Income funds have been the best performing debt funds in the past year (see table) because they had increased their portfolio maturities in the past few months.
Tax-free bonds: During the past year, a number of tax-free bond issues have hit the market. These do not offer any tax deduction to investors, but the interest is tax-free, which makes them very attractive for those in the higher tax slabs of 20-30%. While the coupon rate of 8% is lower than that offered by bank fixed deposits, the post-tax yield is much higher. The income from a fixed deposit is fully taxable. The post-tax returns from a fixed deposit that offers 9% is only 6.3% for someone with an annual income of over 10 lakh. For those earning 5-10 lakh a year, the 20% tax will pare the yield of the fixed deposit to 7.2%. Keep in mind that the tax is payable on an accrual basis every year even if you have opted for the cumulative option.
The government had allowed state-owned infrastructure companies to raise up to 60,000 crore from the Indian public during 2012-13. However, so far only a fraction of this amount has been raised through tax-free bonds from companies like Power Finance Corporation, Hudco, India Infrastructure Finance Co, National Highway Authority of India and the IRFC. One such issue from IRFC closes on 29 January. If you missed this bus, consider other forthcoming issues before 31 March. This may effectively be your last chance to lock in at the existing high rates. Indications are that the Budget may not allow state-owned firms to float tax-free bonds.
Most of the tax-free bonds have high credit rating, which means the risk of default is very low. The tenure of these bonds is 10-15 years, so it gives investors an opportunity to lock in for a fairly long period. The best part is that these can be traded in the secondary debt market. You can cash out after a few years. If interest rates are down by then, you will pocket a neat sum in capital gains as well. “Tax-free bonds are ideal for investors in the high tax bracket. They provide enough liquidity and have no reinvestment risk,” says Nath.
Fixed deposits: For those in the lower income brackets, bank and corporate deposits are a better option. Banks and companies are offering attractive rates on fixed deposits, but this could change in the next few months. The deposit rates have already started moving south. Don’t be lured by very high rates of short-term deposits. A 6-9 month deposit could offer you up to 9.5%, but there is a very high reinvestment risk. When the deposit matures, you will not be able to reinvest the proceeds at a high rate. Given that the RBI is likely to ease rates further, the prevailing rate 6-9 months from now may be in the region of 7-8%. It’s best to opt for a longer duration so that you can benefit from the high rates for the rest of the tenure. However, only a few banks offer fixed deposit tenures of 8-10 years.
The deal is sweeter for senior citizens, who get 0.25-0.75% higher interest on their deposits. Some companies, such as housing finance major HDFC, offer their customers an additional 0.25% interest on deposits.
Recurring deposits: If you don’t have a large sum to put away in a fixed deposit immediately, consider starting a recurring deposit, where you invest a fixed sum every month. Once you start a recurring deposit, the rate remains uniform for the rest of the tenure. However, unlike fixed deposits, you can’t just walk into any bank and open a recurring deposit. Banks insist that you have a savings bank account with them from which a fixed amount will move to the recurring deposit every month.
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