Avoid chasing yield blindly in scenario of falling interest rates

Give equal weight to safety so that you avoid loss of capital in your fixed-income portfolio

Following a 50 basis points rate cut by the Reserve Bank of India (RBI) on June 6, banks have lowered their fixed deposit (FD) rates by 25-50 bps. While investors should explore better-yielding options, they must not compromise on safety.

 

Debt funds

 

Debt mutual funds (MFs) have delivered better returns than FDs over the past couple of years amid softening rates.

 

The repo rate now stands at 5.5 per cent. “The RBI has suggested that there is not much scope for further rate cuts. This means the duration strategy, which has been performing for the past two years, may not yield the same kind of performance. Investors should now move to an accrual-oriented strategy — categories like money market funds and low-duration funds,” says Mahendra Kumar Jajoo, chief investment officer – fixed income, Mirae Asset Investment Managers (India).

 

Devang Shah, head – fixed income at Axis Mutual Fund, also believes that long bonds have limited room to rally further. “Rate cuts are likely to be limited — one or two — and that too only if there is a growth shock or if inflation moves even lower,” says Shah. 

 

A significant portion of the rally in debt funds was fuelled by liquidity infusion. “As there is ample liquidity in the system, investors may consider incrementally shifting their investments into short- and medium-term funds,” says Shah.

 

Debt-plus-arbitrage funds can potentially be a sensible option for investors. “Investors with a minimum two-year horizon may consider this category. With such a horizon, it becomes a tax-optimal solution since investors get taxed at a lower rate of 12.5 per cent,” says Shah.

 

Investors who are heavily overweight on long-duration funds should change their allocation. “They should move gradually from duration to accrual strategy over the next three months,” says Jajoo.

 

Dynamic bond funds may be retained, as their fund managers are likely to adapt to this environment by reducing the average maturity of their portfolios.

 

Small savings schemes

 

Small savings schemes carry no credit risk as they are backed by the Indian government.

 

Some experts suggest going for Public Provident Fund (PPF, interest rate 7.1 per cent) and Sukanya Samriddhi Yojana (SSY, interest rate 8.2 per cent).

 

“Among small savings schemes, these are the only products that offer tax-free returns,” says Deepesh Raghaw, a Securities and Exchange Board of India registered investment advisor (Sebi RIA).

 

Rates cannot be locked in for the entire tenure in these schemes. They are revised quarterly and could fall when they come up for revision at the end of June.

 

If you wish to lock in rates for the tenure, consider post office deposits. “If the interest rates on them are higher than on bank deposits, and if you can deal with the operational challenges that arise while transacting at a post office, go for them,” says Raghaw. 

 

Arnav Pandya, founder of Moneyeduschool, recommends the Senior Citizen Savings Scheme (SCSS, interest rate 8.2 per cent) in addition to the two products mentioned above. SCSS allow investors to lock in the rate for the entire tenure. But interest income from it is taxable.

 

These schemes are suited for longer-term goals. “All these three products serve specific goals. PPF is well suited for retirement savings. SSY caters to the needs of the girl child while the Senior Citizens Savings Scheme (SCSS) meets the needs of senior citizens,” says Pandya.

 

RBI floating rate savings bonds

 

  These bonds carry no credit risk and may offer higher rates than FDs (8.05 per cent currently), especially for non-senior citizens. However, the interest is taxable and the rate cannot be locked in for the entire tenure.

 

“It offers an interest rate equivalent to National Savings Certificate plus 35 bps,” says Raghaw. He adds that rates of small savings schemes tend to be sticky on the downside due to political compulsions.

 

Another drawback of these bonds is limited liquidity. Only senior citizens are allowed premature exit. Those above 80 may exit them after four years; those between 70 and 80 may exit them after five years; while those between 60 and 70 may exit them after six years.

 

Corporate bonds

 

Bond platforms now offer access to corporate bonds, many issued by non-banking financial companies (NBFCs). Many of them even now provide double-digit returns. However, these bonds also come with greater risk.

 

Experts suggest doing due diligence on the entity whose bonds you plan to invest in. “Many of the borrowers are small NBFCs that give out unsecured loans. They may offer you high interest rates, but the chances of defaults are also high,” says Pandya. 

 

He recommends focusing on established issuers. “Individuals with larger portfolios, who are capable of taking some risk, may go for these bonds. First-time investors, those with smaller portfolios, and senior citizens should avoid them,” says Pandya.

 

Raghaw also suggests sticking to AAA-rated bonds. “Invest in listed bonds held via demat accounts. Invest only in bonds of marquee corporates. You may also go for PSU bonds,” says Raghaw.

 

Finally, experts say that peace of mind should be the primary criterion when building the fixed-income portfolio. They caution against chasing yields blindly in a falling rate environment as it could result in loss of capital.