Real Returns. How to beat falling interest rates

Interest rates on your fixed income instruments, already on a slippery slope, are set to see a sharper slide in the coming months, thanks to banks being flooded with deposits after demonetisation. The yield on the 10-year government security, used as benchmark for long-term savings instruments, has fallen from 7.7 per cent in January 2016 to 6.2 per cent now. The yield on three-month treasury bills is down from 7.2 to 5.9 per cent.

If you are a saver whose favourite instrument is the bank fixed deposit (FD), you will already be feeling the heat. Leading banks have announced FD rate cuts in the last week which have taken rates on one-year FDs below 7 per cent. After accounting for income tax at slab rates, the effective post-tax interest works out to just 4.9-6.3 per cent now.

But amid tumbling rates on bank FDs, here are four vehicles that can help you earn higher returns.

If safety is your prime concern, fixed rate post office schemes are your best bet. Interest rates on post office schemes are now reset at the beginning of every quarter. As the rates are pegged to government securities, they will be slashed in January.

But not all post office schemes are variable rate products. Some allow you to lock into a rate for a five-year term. The POMIS (post office monthly income scheme), post office time deposits and National Savings Certificates (NSC), apart from the Senior Citizen Savings Scheme (SCSS) are such fixed rate products.

After recent cuts, leading banks offer 6.5 per cent to 6.75 per cent on five-year FDs. But NSC (8 per cent), POMIS (7.7 per cent) and the five-year time deposit (7.8 per cent) offer over 1 per cent more. If you are a senior citizen (60 and above), the SCSS still offers 8.5 per cent. The interest on these options is taxable.

To take advantage of this window, you must act before January, but there are trade-offs. While investing in these instruments, you forego exit for the next five years. If interest rates bottom out next year and climb very steeply, you will be unable to cash out.

If you fall in the 30 per cent tax bracket, you can consider arbitrage mutual funds. Arbitrage funds offer debt-like returns from trading on the arbitrage opportunities in the stock market. They do not take on any equity risk and deliver a positive return, irrespective of whether the stock market rises or falls. Indian arbitrage funds use cash-futures arbitrage in highly liquid single-stock futures. The cash-futures spread essentially captures borrowing costs for traders. Therefore, returns on arbitrage funds closely track short-term interest rates.

Arbitrage funds offer two advantages. They are treated as equity funds for tax purposes, which means dividends are tax free. Capital gains after one year are also tax-free. They are also open-ended and allow you to invest or withdraw anytime.

Arbitrage funds in the last three years have managed a 7.5-8.5 per cent return. But going forward, expect their returns to mirror market interest rates and fall to 6-7 per cent tax-free.

Leading banks have had a problem of plenty since the demonetisation drive and have been quick to slash rates, but recent entrants to the banking sector are still keen on attracting deposits. Opening FD accounts with new banks may thus fetch you attractive rates, with safety. While writing this, IDFC Bank offered 8.25 per cent for a 366 day deposit. Bandhan Bank paid 8 per cent for one-year deposit and RBL Bank offered 7.75 per cent for one- to two-year deposits.

NBFCs too may not be as quick to slash their deposit rates as banks. This offers a limited window of opportunity.

With some segments of NBFCs hit hard by the cash crunch, it is best to stick to AAA-rated NBFCs. While Mahindra Finance (rated FAAA by Crisil) offering 7.8-7.9 per cent on one to two year deposits and HDFC (rated AAA by both Crisil and ICRA) with 7.8 per cent on 22-month deposits, are good options.

It is best to stick to shorter tenures of one to two years, as longer tenures do not offer incrementally better rates. Also, you will retain the flexibility to reinvest if rates reverse in two years.

Falling interest rates in the economy are always good for one asset class — equities. Therefore, once the dust from the demonetisation settles, one can expect equities to make a comeback and deliver reasonable returns over a three to five-year time frame. Hybrid debt-oriented funds which take a 15-20 per cent bet on equities, while retaining a conservative debt portfolio present a good buy now.

But debt-oriented hybrid schemes comes in many shapes and sizes. If you are keen to reduce risks, it is best to choose funds which have a proven record of positive returns across equity and bond market cycles in the past.

HDFC Multiple Yield Fund, which parks 85 per cent of its portfolio in short-maturity, top quality corporate bonds and 15 per cent in high dividend yield stocks, offers a nice blend of low risk with higher yield.

If you are up for a bit more risk in your debt portfolio, Birla Sun Life MIP II Savings 5 offers it. It takes an 80 per cent debt exposure, mostly in long-term G-Secs to make the most of falling rates; the equity portion is in quality stocks.

IDFC Asset Allocation Fund – Conservative Plan parks 10-15 per cent in equities, up to 90 per cent in debt and up to 15 per cent in gold or money markets. The debt portion is parked in the short term and liquid funds managed by IDFC MF. The equity portion is more aggressive with a mid-cap tilt.

Gains from these funds are taxable at your slab rate if you exit within three years. You can claim indexation benefits on long-term capital gains tax, if you hold for over three years.