Interesting times for deposits and bonds

After the election results, the fireworks in the stock market may have hogged all the attention, but there are many interesting opportunities for bond investors too. Let’s look at the prospects for traditional fixed deposit (FD) investors first.

FD rates may rise

With business-friendly Modi installed at the helm of an ultra-stable Government, business confidence is likely to receive an immediate boost, even before any policy changes are initiated. This will mean higher demand for loans from the banking system.

This may in turn force banks, which have until now been dealing with slow loan offtake, to scramble for new deposits from the public. Banks could open up special deposit windows or raise one-three year FD rates to attract depositors.

This will spell a great opportunity for you, if you are a passive FD investor, to lock into high interest rates, before interest rates soften. The same logic holds good for FDs from NBFCs and companies too. Therefore, watch out for those ‘special deposit’ windows from banks and high-rate FDs from NBFCs.

Avoid entities with lower credit ratings for now. But lock into banks or top-rated issuers for as long a period as possible, as high interest rates may not last very long.

This is also a good time to bump up your investments in the small savings schemes. You must know that the annual interest rates on small savings schemes are pegged to government bond yields at the beginning of each financial year.

When the interest rates on these schemes were set for this fiscal (2014-15), government bond yields were ruling quite high. But this happy state of affairs may not last. If market interest rates fall, the rates on small savings schemes could be cut for next year.

This is why maximising your investments in the Public Provident Fund (PPF) and National Savings Certificates (NSC) makes eminent sense now.

Today, the PPF offers an interest rate of 8.7 per cent per annum. This return is tax-free and your original investment also gets tax breaks under section 80C. The five-year NSC, with an 8.5 per cent interest rate, is a good option too, yielding better returns after taxes than comparable bank deposits.

Finally, with the Modi Government promising quick reforms and big-ticket projects, trading opportunities may crop up in long-term gilts and bonds too.

The ‘political refresh’ theme may see FIIs raising their bets on Indian government securities (G-Secs) and bonds. FIIs have been as bullish on Indian bonds in the run-up to the election results, as they have been on equities.

Of the $11-billion FII flows into Indian markets between September and May, $5 billion has flowed into bonds. Therefore, it is reasonable to expect further inflows after the BJP win.

A rising tide of FII money flowing into Indian bonds can prop up the rupee and ease the pressure on the RBI to hold up the official interest rates. However, whether the RBI will immediately reduce its policy rates is still a difficult call as consumer price inflation remains a concern.

But the expectation is that the combination of a stronger rupee and a better fiscal situation (if the Modi Government manages this), will provide the central bank with the elbow room to ease rates over the next year or 18 months.

This expectation can lead to a price rally in long-term bonds over the next few months.

A good way to play this would be through aggressive debt funds such as gilt funds, long-term income funds and dynamic bond funds with a high gilt and long-bond allocation.

However, as most informed bond investors, including FIIs, will be jostling to bet on this opportunity, the accompanying risks could be high. Buy gilt funds or long-tenor bonds from the secondary market only if you can handle quite a bit of swing in your returns.

Don’t forget that, with the stock market reviving, it may make far more sense to take risks with equities than with bonds in your portfolio.

Even if you stick to under-valued bluechips (which still exist), the payoffs may still be far higher than anything you can make from bond trades.