Debt investors in India are forced to make some devil-and-deep-sea choices right now.
If you seek capital safety, deposits with the top banks or India Post force you to putup with negative real returns, with interest rates lower than consumer price inflation.
If you look to entities such as small finance banks and old private sector banks for more respectable rates of 7-8 per cent, there’s not enough compensation for the risk to your capital.
Options such as the National Savings Certificates (NSCs) or Kisan Vikas Patra offer growth, but their lock-ins force you to settle for negligible real returns for several years. Market interest rates have plunged below repo rates, sharply reducing return prospects for debt funds too.
So, is there any way you can get competitive rates on your debt investments today, without risking your capital or suffering long lock-ins? Floating-rate instruments allow you to have the cake and eat it, too.
But what if interest rates in India head even lower and flirt with zero like in the Western world? Given the dynamics of inflation and growth in India, we believe this is highly unlikely. There are three reasons why we think interest rates in India are close to bottoming out and may even head up over the next one year. If you’re willing to go with this view, you can use floating-rate debt options to gain from this opportunity.
Case for a bottom
Stubborn inflation: The CPI inflation trajectory in India has surprised most experts on the upside recently, with general inflation staying at 6-7 per cent and the food component at 9-11 per cent for the last seven months. If inflation sustains this trajectory, the Monetary Policy Committee (MPC)will have a hard time ignoring it, to continue with its accomodative policies. The primary mandate of the MPC is to keep CPI inflation contained within the band of 2-6 per cent.
In the past, the MPC turned quite nervous every time CPI inflation topped 6 per cent. But in recent months, recession worries triggered by Covid-19 have prompted it to ignore CPI readings and hang on to its accommodative stance for many months. While the committee has repeatedly projected that the recent CPI spike will cool off soon, its benign inflation forecasts have turned out wrong for seven quarters now (see table). This makes one sceptical of similar predictions it has made this week, for inflation to moderate from this quarter. Under the Monetary Policy Agreement, the RBI owes a written explanation to the Centre if the CPI inflation moves beyond 2-6 per cent for three consecutive quarters.
That this spell of returning inflation is global in character, also makes benign forecasts susceptible to error. (see table).
Economy turning: The current down-cycle in interest rates in India is one of the longest in recent history. India’s repo rate has fallen 400 basis points from 8 per cent in 2014 to 4 per cent now and this rate cutting cycle has gone on for six years.
The repo rate is now its lowest level in three decades. Even during the global financial crisis, the repo rate did not fall below 4.75 per cent. Present policy rates go against the RBI’s stated intent of ensuring a 100-150 basis point positive real return to savers.
While the MPC has been on an easing spree, RBI has been swamping the markets with extra liquidity through market interventions to help stressed borrowers. This has had the unusual effect of pushing short-term borrowing costs for leading companies below policy rates, an unsustainable situation.
These Covid-special easy money policies have so far been justified by the argument that the ongoing recession calls for extraordinary measures from the RBI and MPC. But they would become difficult to justify if there’s increasing evidence of the economy getting out of its sickbed. Voices are already piping up for the RBI to withdraw this excess liquidity to quell inflation. It appears only a matter of time before this happens and market rates normalise.
A growing economy would mount pressure on the MPC to peg up the repo rate to more normal levels of 5.5-6 per cent.
Hard on savers: While the prospect of banks offering free loans at zero rate looks alluring on paper, near-zero rates can do far more harm than good in an economy like India, where household savings substantially exceed household borrowings. There’s already realisation in policy circles that indiscriminate rate cuts dent household incomes and discourage savings. The Centre’s reluctance to prune small savings interest rates below a certain point, despite MPC actions, is evidence of this.
All these factors suggest that even if a rate-hike cycle in India is some way away, the repo rate could bottom out close to current levels. If the economy picks up, a 100-150 basis points increase over the next 12-18 months is a possibility. Market interest rates by their very nature pre-empt policy actions and are likely to move up before MPC reverses gear.
Floater options
RBI Floating Rate Savings Bonds
If you’re seeking guaranteed income with zero worries on safety, the Floating Rate Savings Bonds (FRSBs) 2020 issued by the Centre should be your top choice. These bonds only carry regular interest pay-outs, carry a seven-year lock-in period and are available on tap from leading banks.
The interest is taxable at your slab rate. Unlike the small savings schemes, there’s no upper limit on your investments. The current interest rate, payable in January 2021, is 7.15 per cent. It is reset every six months by the government at a 35-basis point spread over the ruling rate on the five-year NSCs.
These bonds are made particularly attractive by the promised spread over the NSC. The rulebook says that the NSC must offer a 25-basis point spread over the five-year G-Sec, but in practice, since 2016, it has offered 30-150 basis points more.
The FRB, therefore, offers at least a 60-basis point premium over the five-year G-Secs, despite being a similar instrument. Should market interest rates rise over the next few years, this bond will ensure that you benefit by way of rising income. The long lock-in and lack of early exit options are the only minuses.
Floating rate debt funds
If you can’t afford extended lock-ins for your debt money, floating rate debt funds you a nice option to benefit from rate moves with any-time liquidity. Though the paucity of floating-rate bonds in India has traditionally imposed constraints on these funds, they now use interest rate swaps on fixed-return bonds and futures to mimic floating rates. At least 65 per cent of a floater fund’s portfolio is required to be invested in floating instruments.
Most floater funds invest in a mix of Central and State government bonds and AAA corporate bonds, while some take on credit risk to a limited extent in their portfolios. Growth options of floater funds are taxed as short-term capital gains at your slab rates for less than three years and as long-term gains if held longer, at 20 per cent with indexation benefits.
Floating-rate funds deliver returns that fall somewhere between short-term debt funds and corporate bond/banking & PSU funds. They run average maturities of 1-4 years, which bumps up returns compared with ultra-short and short-term funds. Their returns, however, tend to be quite volatile, with the possibility of losses if held for less than a year.
Trailing returns on the category (as of November 27) showed a CAGR of 8.9 per cent in one year, 7.9 per cent over three years and 7.8 per cent over five years. But given the sharp fall in market rates, returns now are likely to be far lower with . portfolio yield of 3 to 5.5 per cent. Aditya Birla Sun Life Floating Rate Fund, HDFC Floating Rate Debt Fund and Kotak Floating Rate Fund make the cut on track record, portfolio quality and costs.
Public Provident Fund
The PPF may not readily spring to mind as a floater scheme. But it is one because the quarterly interest rate resets in the scheme apply to your entire account balance and not just to your investments for the year. The scheme offers no payout and only accumulates interest. It limits your annual investment to ₹1.5 lakh and offers a tax exemption on this. Final withdrawal proceeds are tax-free, too.
The interest rate on the PPF is supposed to be at a 25-basis point spread over the 10-year G-Sec, but, in practice, it has been set much higher. The rate for the October-December 2020 quarter is 7.1 per cent. Attractive cumulative returns, tax-free status and safety make PPF a great choice for those seeking compounding from debt though its long lock-in of 15 years is a key negative.
If despite the above arguments, you would not like to stick your neck out on floating rate options, no worries. You can still keep your options open by investing in fixed rate options with short tenures of upto one year.