for investors to seek better returns by choosing carefully from a menu
of debt investments that combine good returns with safety.
Rising inflation and spiralling interest rates have infused a big dose
of uncertainty into the outlook for stocks and made them lurch wildly
between one trading session and another. But these very factors present
a window of opportunity for debt investors, who can now look forward to
lucrative investment returns. Interest rates which, by end-2007, were
expected to peak and embark on a gentle downward slide, have
unexpectedly climbed further in the past six months.
The central bank's attempts to cool runaway inflation through hikes in
policy rates and mop up excess liquidity has pushed up the yields on
debt instruments across tenures. The repo rate (the rate at which banks
borrow from the RBI) is up from 7.75 to 8.5 per cent over this period,
while the CRR (cash reserve ratio, the proportion of funds that banks
have to statutorily park with RBI) will be at 8.75 per cent (up from
7.5 per cent in December), once recent increases take effect.
Interest rates on government securities and corporate bonds have
already risen in response. In barely six months from January to July,
yields on one-year government bonds have climbed from 7.45 per cent to
9.25 per cent and those on 10-year gilts from 7.8 per cent to 9.4 per
cent.
Blue-chip corporate bonds (AAA rated) now offer 10.6 per cent, 1.5 per
cent more than levels barely six months ago. These trends are also
being reflected in fixed debt options such as bank and company
deposits. So, how can investors capitalise on rising interest rates?
From a menu of debt investments that offer market-related interest
rates, what should they now favour? How should they deal with their
big-ticket borrowings?
Scope to head higher
Before proceeding to answer these questions, a key call that investors
will have to make is where interest rates will head from here. Will
they keep rising, offering even better opportunities for debt investors
in the months ahead? Or will they tumble, requiring you to grab the
good debt deals while they last?
Fortunately, that's an easy call. Today, bankers and economic
forecasters are surprisingly united in their verdict that India's
interest rates will continue their climb at least till the end of 2008.
Inflation, at over 11 per cent, is well out of the RBI's comfort zone
and forecasts suggest that the number is likely to remain near the
double-digit mark over 2008 and stay out of the comfort zone, well into
2009.
Bankers believe that as long as inflation remains well above the target
zone, policy measures to curb liquidity will continue. This may mean
that interest rates will likely increase through 2008 and may not taper
down in a hurry even in 2009.
Over the next few months, predictions are for a further 0.25 to 0.50
per cent increase in the repo rate and a 0.50-1 per cent increase in
the cash reserve ratio (CRR) from the current levels. This is bound to
reflect in debt returns across a range of instruments. Having decided
that interest rates would continue their climb, what are the options
for your portfolio?
How they stack up
Bank term deposits: Interest rates on term deposits, which were
beginning to soften in end 2007, are now upward bound. Several banks
have revised interest rates on their term deposits effective July 1,
with the sharpest revisions happening in the 1-2-year windows.
Tightening liquidity is also prompting banks to open up their "special
deposit" schemes once again. SBI now offers 8 per cent on deposits from
181-364 days and 9.5 per cent on 1-3 years. ICICI Bank offers 8.5 per
cent on terms ranging from 1 year to 389 days and also offers a 390-day
deposit with a 9.25 per cent interest rate.
Recommendation: Attractive rates and high marks on 'safety' make this
an opportune time for the more passive investors to sweep their savings
bank surpluses into bank term deposits. The best deals in bank term
deposits are now available in the 1-2 year window; locking in for a
longer tenure does not necessarily yield better returns.
With more hikes in the CRR expected, term deposit rates are likely to
tread further upwards in the coming months. Investors who are willing
to actively track interest rates can park surpluses in short term
options (read: liquid MFs) and switch into term deposits after another
round of revisions in interest rates. Waiting awhile may allow you to
lock into higher rates for the long term.
Fixed maturity plans: If bank term deposits score high on the safety
factor, FMPs rolled out by mutual fund houses offer much better
post-tax returns. FMPs, usually open for short periods of 3-4 days, are
available in terms ranging from 3 months to slightly over one year and
allow you to lock into prevailing interest rates for corporate bonds
and gilts when you buy the fund.
As indicative yields (now at 10-11 per cent for one-year plus FMPs) are
provided at the outset, returns are fairly predictable. Shopping for
FMPs which offer good rates for the shortest possible term makes sense,
as this will allow you flexibility to capitalise on further rate
increases. While term deposits suffer taxation at your marginal tax
rate, returns on FMPs are subject to capital gains tax.
Recommendation: One year-plus FMPs may help investors in the 30 per
cent tax bracket earn a higher effective return compared to term
deposits offering similar rates. But do note that an FMP carries a
higher risk profile than a bank deposit. Chasing an FMP purely on the
basis of an exceptionally high "indicative" yield is not advised as
this may require the manager to assume higher levels of risk, while
shopping for better yields.
Company fixed deposits: Interest rates on deposits taken by companies
too are trending up, with NBFCs leading the pack in offering attractive
rates. Interest rates on one-and two-year deposits from manufacturing
companies now fall in the 8.5-11.5 per cent range. After revisions
effective July 1, Sundaram Finance offers 10 per cent on its one-year
FD and 10.50 per cent on two and three year FDs. This remains an
attractive option for conservative investors with low tax incidence.
Recommendation: Investors should opt for company FDs only if they offer
a sufficient "risk premium" over bank term deposits, given recent
revisions in the latter. Analysis of company financials is a must
before you invest. With margin pressures and a tough macro environment
set to take a toll on company earnings over the next couple of years,
companies in capital-intensive businesses may face liquidity
constraints. Bank deposits may score on safety and flexibility (more
in-between tenures) and FMPs on tax efficiency.
Short-term debt funds: If you would like the returns on your debt
investments to "float" up with rising interest rates, short-term debt
mutual funds (maturity periods of less than a year), which offer
market-related returns, appear to be the best option.
The high liquidity on such products (you can exit at NAV-based prices
any time) is a big plus, as it allows plenty of leeway to switch to
higher yielding options at the exact time of your choice.
Medium and long term debt funds (check out the average maturity period
of the portfolio) are best avoided, as they may deliver flat or
negative NAV returns (due to falling bond prices) in a scenario of
rising interest rates.
Floating rate funds, despite their name, suffer from disadvantages
relating to the availability and valuation of instruments. Therefore,
sticking with Liquid and Liquid Plus funds and Short-term bond funds
appears to be the best option.
Recommendation: Returns for short-term bond funds have been in the 8
per cent range for one year, while liquid funds have delivered 8.3 per
cent.
There is also potential for returns to move up from current levels, as
market yields on short term instruments trend up on tight liquidity.
But as there is significant divergence between funds, look for
established debt managers with a good 3-year record. These debt funds
are a good parking ground for your surpluses if you would like to wait
before you lock into a term deposit or are looking to re-enter stocks
at a later date.
Restructuring borrowings
Investments apart, rising interest rates may also require you to
re-evaluate your decisions to borrow. Home loan interest rates
generally tend to be quite sticky and have not risen in tandem with
market interest rates over the past year.
Recent increases, made after a year's gap, have taken floating rate
home loan interest rates to 11 per cent for leading providers such as
ICICI Bank and HDFC. A further 0.25 to 0.50 percentage point increase
cannot be ruled out, to compensate for further increases in market
rates.
If you are a borrower, two key decisions that arise from this are:
whether you should switch/opt for a fixed-rate home loan and whether
you should prepay an existing loan. On the first, the answer appears to
be a "no" at this juncture.
Though fixed rate loans have the advantage of predictable EMIs, they
appear too expensive at this juncture — at interest rates of 13-14.75
per cent p.a.(without a reset clause), considering that floating rates
are only expected to move up by 0.25-0.50 percentage points. Both the
competitive scenario as well as the fear of defaults is likely to make
banks tread cautiously on pegging up floating rates on home loans at
frequent intervals.
A decision to pre-pay the loan will depend on how much surplus cash you
possess and the rates at which you are hopeful of reinvesting this. If
you are in the 30 per cent bracket, tax savings on the interest outgo
will tend to trim the effective interest rate on a 11 per cent floating
rate home loan to 7.7 per cent.
this "hurdle" rate of return over the long term. Prepayment penalty,
usually levied at 2 per cent of the outstanding loan, will also add to
the cost of prepayment.
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