With little clarity on the way interest rates are headed, we tell you how you can make money from fixed-income instruments.
Always expect the unexpected. This is the lesson from the latest monetary policy review of the Reserve Bank of India (RBI). While most people were expecting that the RBI will continue its "accommodative" stance and cut the repo rate by 25 basis points or bps (100 basis points is equal to one per cent), the central bank decided to keep the rate steady at 6.25 per cent in its first monetary policy review of 2017.
What surprised the market more was the change in the RBI's stance from "accommodative" to "neutral". It cited the sticky core (non-food/fuel) inflation, firming up of global commodity prices, especially of oil, and strengthening of the US dollar as reasons for the change in stance. This means the RBI has kept options open to move interest rates in either direction. Experts are anticipating that this could be the end of the rate cut cycle that began in 2015.
"Having changed stance from accommodative to neutral on account of upside risks to inflation and excess liquidity, the RBI has hinted at restricted scope for further easing in the near term," says Santosh Kamath, CIO and MD, Local Asset Management, Fixed Income Franklin Templeton Investments, India.
"The RBI left the repo rate unchanged at 6.25 per cent despite lowering its inflation outlook and GDP growth projections. There seems to be a greater concern about global oil/commodity prices. This indicates a higher bar for rate cuts. The change in stance from accommodative to neutral suggests we might have reached the end of the rate cut cycle," says Arvind Chari, Head of Fixed Income & Alternatives, Quantum Advisors.
While 2016 saw a correction in long-term bond yields (coupon rate divided by the bond's market price) in most regions, including Europe, Asia and other emerging economies, including India, 2017 has seen a reversal of the trend. "The start of 2017 has seen a reversal in the trend of falling bond yields as economies shift gears to grapple with strengthening fuel and metal prices, which have a tendency to stoke inflationary expectations," says Kamath of Franklin.
After falling to a multi-year low in 2016, the yield on 10-year benchmark government securities spiked by 30 bps to 6.75 per cent after the RBI's policy announcement on February 7. G-Sec yields rose from 6.43 per cent to 6.85 per cent between February 7 and February 10. The yields are now at the pre-demonetisation level. Experts expect a lot of volatility in yields in the short term.
"In the near term, the yield will be primarily influenced by liquidity, supply of G-Sec paper, and buybacks. In our opinion, yields on long-term instruments will remain more volatile than those on short-term instruments," says Rupa Rege Nitsure, Group Chief Economist, L&T Financial Services.
"Ten-year yields could touch around 7.25 per cent if the RBI remains on a pause mode in 2017. If a 25 bps cut materialises, they could settle around 7 per cent. In both cases, the assumption is that liquidity will remain in the surplus territory," says Gaurav Kapur, Chief Economist, IndusInd Bank.
Will RBI Hike?
Strengthening bond yields indicate that interest rates may not fall from here. Experts say the RBI's call on interest rates will depend on both domestic and global factors. However, they add that given the fall in GDP growth and poor credit offtake, the RBI will increase rates only if global or domestic macro factors deteriorate more than expected.
"We expect inflation to remain at less than 5 per cent in 2017. If monsoon is normal, food prices, too, will remain under control. But in case of a rise in global commodity prices, especially if oil shoots above $70, the RBI may consider increasing the repo rate. Otherwise, it is unlikely that it will go for a rate increase," says Chari of Quantum Advisors.
"The upside in interest rates is likely to be restricted by ample liquidity and weak credit demand," says Gaurav Kapur, Chief Economist, IndusInd Bank.
Nitsure of L&T Financial Services believes interest rates will remain volatile rather than move in any one direction during 2017/18.
Here's how investors can gain from these trends.
Fixed Deposit Investors
Fixed deposits provide safety of capital and guaranteed interest. This makes them the most sought-after debt investment despite the fact that the interest earned is taxable. At present, interest rates on bank fixed deposits are at a 10-year low. The RBI has cut the repo rate by 175 bps since 2015. Flushed with liquidity after demonetisation, banks slashed interest rates substantially. Right now, State Bank of India is offering 6.90 per cent on a one-year fixed deposit; in 2015, it was 8.5 per cent. After tax, the effective rate for a person in the highest tax bracket of 30 per cent works out to be 4.83 per cent, which is very low.
As repo rates are unlikely to fall further, fixed deposit rates may not go down from here. This will be good news for many investors, especially retirees, several of whom park their retirement savings in bank deposits for regular income.
"As the repo rate, at which banks borrow from the RBI, goes down, banks generally cut fixed deposit rates. This has been the trend in the past. But as the RBI has signalled that it is unlikely to go for a rate cut in the near future, fixed deposit rates may not go down further by much," says Chari of Quantum.
"It will depend on the liquidity in the banking system and the pace of re-monetisation. Bank rates are at very low levels. I don't see any significant correction. Also, bank fixed deposits compete against small savings schemes (SSS), which are offering higher rates. If fixed deposit rates go down from here, investors may shift to SSS, which banks wouldn't want to happen," says Lakshmi Iyer, Chief Investment Officer (Debt) and Head of Products, Kotak Mutual Fund.
However, some new small banks are paying higher interest than commercial banks to expand their customer base.
Investors in higher tax brackets have to look beyond fixed deposits as taxes can substantially erode the value of the interest earned. Debt mutual funds are one of the most recommended alternatives. These have the potential of delivering better returns. Plus, their returns are less lightly taxed (gains over three years qualify for indexation benefits).
For instance, in 2016, falling interest rates and softening bond yields helped long-term bond funds and dynamic bond funds deliver double-digit returns. Interest rates and bond prices move in opposite directions. As interest rates fall, bond prices go up, and vice versa. Debt mutual funds, especially those that invest in longer maturity papers, perform better when interest rates are falling. This is because the demand for higher-coupon bonds held by them rises in such a case. As a result, their net asset value increases. Long-term bond funds invest in papers with long maturity, including G-Secs, which are highly traded and, hence, volatile. Dynamic bond funds have the flexibility to change the average maturity of the portfolio as per the interest rate scenario.
However, the RBI's recent move came as a shocker and many experts, including fund managers of debt mutual funds, were caught off-guard. After the monetary policy announcement, bond yields strengthened, and most debt funds, barring liquid funds that invest in debt papers of up to 61 days, delivered negative returns of 0.30-2 per cent. Some funds in the medium- to long-term category, such as L&T Triple Ace Bond Fund, fell as much as 2.57 per cent on February 8, as per the data provided by Morningstar India. Debt funds generally take two-three months to deliver such returns.
So, what should be the strategy in such a scenario?
Continue To Hold Dynamic Bond Funds: Experts say long-term bond funds, especially those that invest only in long-term G-Secs, are not for retail investors. This is because timing the entry and exit in these funds is very important. But dynamic bond funds are still a good option for the long term given that they have the flexibility to change the average maturity of the portfolio as per the changes in the interest rate scenario.
Vidya Bala, Head of Mutual Fund Research, FundsIndia.com, says, "Investor should enter debt funds with a minimum time frame. They shouldn't rush to sell dynamic bond funds after seeing volatility in the short term as these are for investors with a holding period of at least three years."
"The RBI definitely surprised markets by changing its stance from 'accommodative' to 'neutral'. As yields rose nearly 35-40 bps, duration funds were impacted. But we believe that investors can continue to remain invested in debt funds as the country's macro fundamentals are quite favourable," says Rahul Goswami, CIO- Fixed Income, ICICI Prudential AMC.
However, investors will have to temper expectations from dynamic funds, as they may not give double-digit returns like they delivered in 2016.
Short-Term Funds To Perform Well: Conservative investors who are risk-averse even in the short term can look at short duration funds; these are likely to do better than long duration funds.
"Fresh investments can be made in ultra-short-term and short-term debt funds holding good quality paper based on one's investment horizon. Allocation to long duration bond funds such as gilt and income funds (medium- to long-term bond funds) can be avoided. Investors with allocation to long duration bond funds such as gilt and income funds could reduce exposure (subject to exit loads and tax implications)," says Dhaval Kapadia, Director, Portfolio Specialist, Morningstar Investment Adviser India (see table to know which funds to hold as per your investment tenure, as recommended by Vidya Bala of FundsIndia).
"The debt portfolio needs to be designed keeping risk tolerance in mind. Investors with low/moderate risk appetite should use ultra-short-term and short-term hold-to maturity strategies for debt funds. Investors with a higher risk appetite can additionally look at some credit opportunities and dynamic bond funds. It is good if investors stagger their fixed income strategy with different maturities depending on cash flow needs to reduce the reinvestment risk," says Vishal Dhawan, Founder, Plan Ahead Wealth Advisors.
Accrual Funds To Do Better: Debt fund returns come from accrued interest and capital appreciation. Funds that follow accrual strategy invest in short- to medium-term debt instruments and maintain average portfolio maturity of four-five years, thereby generating a substantial portion of their returns from yields.
"These funds are ideal for an investment horizon of one-three years in an environment of stable or rising interest rates. Accrual funds can be broadly categorised on the basis of average portfolio maturities (liquid, ultra-short term and short-term) and credit quality of portfolios," says Kapadia of Morningstar. Funds that follow a duration strategy invest in longer maturity bonds and generate returns primarily from capital appreciation as a result of interest rate fluctuations. "Such funds are ideal for an investment horizon of two to three years in an environment of easing interest rates," he added.
Given the uncertain interest rate scenario, accrual funds are a good option right now if you want lower volatility in returns.
"General global risk aversion, rise in inflation expectations and little scope for policy rate cuts are likely to further steepen the yield curve. Hence, we believe that the primary focus of investors should be protecting the downside risk in a rising interest rate scenario. Lowering portfolio duration and adding to accrual strategies to diversify the portfolio can provide both downside protection and attractive carry to the fixed income portfolio," says Kamath of Franklin Templeton.
Beware of the risk
Debt funds are not safe as bank fixed deposits. The returns are not guaranteed. The change in the RBI's stance and subsequent losses incurred by debt funds has highlighted the interest rate risk in these funds. In another case, Taurus Mutual Fund's four debt funds suffered losses of 7-11 per cent as the rating of debt papers of Ballarpur Industries, in which the funds had invested around 10-12 per cent of their assets, were downgraded. This has highlighted the credit risk (risk of fall in the value of the debt paper that the fund has invested in) that debt funds take. So, while investing in these funds, investors should also be aware about the type of risk they are taking.
Beyond Debt Funds
Tax-free bonds: The interest earned on these bonds, issued by government entities to fund infrastructure projects, is not taxed. Therefore, the risk of default is low. They are also rated by ratings agencies. Tax-free bonds are a preferred choice when interest rates are falling. In 2016, some of these returned 22-25 per cent as interest rates fell and their value went up (as they are giving higher returns, set when they were launched). There are two ways in which one benefits from investing in tax-free bonds - interest and capital appreciation (these bonds are listed on exchanges).
"In 2016, as interest rates fell, some of these bonds saw a 13-14 per cent surge in prices. Due to the coupon rate of 7.5 per cent, the returns came to 22-25 per cent," says Vikram Dalal, Managing Director, Synergee Capital.
At present, yields on these bonds are in the range of 6.05-6.15 per cent, says Dalal; before the last monetary policy, they were around 5.90 per cent, he added. Dalal says these bonds are a good option for those in the 30 per cent tax bracket as their effective yield turns out to be 8.85 per cent on a bond offering a yield of 6.10 per cent.
These bonds have maturities of 10, 15 and 20 years. One can exit before maturity as these are listed on exchanges. But in such a case, you will be liable to pay tax on capital gains. If you sell before one year, the gain will be added to your income and taxed. If you sell after one year, the gains are taxed at 10 per cent without indexation and 20 per cent after indexation. This year, no entity is likely to issue these bonds.
The 8 Per Cent Government Bond
These bonds, with a maturity of six years, are getting a lot of attention due to the 8 per cent interest. "These are a good option for those in the 10-20 per cent tax bracket as under the semi-annual interest rate option the effective yield comes to around 8.16 per cent, higher than what bank fixed deposits are offering," says Dalal of Synergee Capital
Investors can choose the option of getting interest on half-yearly basis or cumulative basis at the end of the tenure. The minimum investment is Rs 1,000; there is no cap. These bonds can be bought from designated banks.
An NCD is a debt paper issued by a company. The issuer agrees to pay a fixed interest on the investment. As the name suggests, these cannot be converted into shares like convertible debentures. An NCD can be both secured and unsecured. In case of secured debentures, which are backed by assets, if the issuer is not able to fulfil its obligation, the assets are liquidated to repay investors holding the debentures. Secured NCDs offer lower rates than the unsecured ones. If you want regular income from NCDs, pick those that pay interest on monthly, quarterly or annual basis. If you just want to grow your wealth, you can opt for the cumulative option, where the interest earned is reinvested and paid at maturity.
Dhaval Dalal of Synergee Capital says, "There are many NCDs available in the market but retail investors should not chase higher coupon rates and compromise on quality. Some good quality NCDs offer yields of 7.25-8.5 per cent, which is better than fixed deposits. Those who fall in the 10-20 per cent tax bracket can invest in NCDs."
Small Savings Schemes
Falling yields of the benchmark G-Secs have also led to a fall in interest rates on small savings schemes such as Public Provident Fund (PPF), Kisan Vikas Patra and Sukanya Samriddhi Scheme. Interest rates offered by PPF and other small saving schemes are linked G-Sec yields of respective maturities.
Despite this, small saving schemes are offering higher interest rates compared with bank fixed deposits. Also, the tax advantage offered by some of these instruments such as PPF, which offers a tax break at all three stages - investment, interest and withdrawal - gives them an edge over bank fixed deposits.
Experts say small saving schemes will continue to deliver better returns than fixed deposits. "The interests rate on these schemes are unlikely to see any sharp fall given the rising bond yields," said Iyer of Kotak Mutual fund.