Small savings rate cut: Who gains, who loses
The cut in the interest rates on small savings schemes has jolted investors. Though targeted schemes such as the Sukanya Samridhi Yojana and the Senior Citizens’ Savings Scheme and the hugely popular Public Provident Fund have seen modest cuts of 60-70 basis, the interest rates on some other instruments have been cut by 100-130 basis points (100 basis points = 1%).
The cut announced on 18 March is only the beginning. Investors should be ready for more changes in the coming quarters. The interest rates on small savings were linked to government bond yields in 2011 and were changed once a year. Now they will be reset every quarter, which will make these instruments market linked. The PPF rate will be 25 basis points higher than the average 10-year bond yield in the past three months. Interestingly, if this formula was applied in the past, the PPF rate would have gyrated wildly over the past 15 years. It would have been as high as 10.6% in 2001 and as low as 5.4% in 2004.
However, long-term investors would not have lost big time if it was implemented earlier. For example, the average interest over the last 15 years as per the new formula would have been 7.89%, only slightly lower than the 15 year historical average of 8.36%.
Though many investors are feeling devastated, the reduction in rates is not catastrophic. In fact, after adjusting for inflation, the real rate of return for PPF investors will still be higher than what it was in 2009-10. Consumer inflation is down to 5.91% while the PPF is offering 8.1%, a real return of 2.19%. In 2009-10, PPF was offering 9.5% but 14.5% consumer inflation meant a negative real rate of return for investors (see graphic). “Investors should focus on the real rates and not on the nominal rates,” says Tanwir Alam, CEO of Fincart.
Will banks follow suit?
Now that small savings rates have been cut, banks may also cut deposit rates. “The high rates of small savings schemes were the reason why banks were not able to cut deposit and lending rates,” says R. Sivakumar, Head of Fixed Income, Axis Mutual Fund. The government acted accordingly, making the biggest cut in one to three year time deposits which offer the stiffest competition to bank deposits. “Bank deposit growth rate came down in the recent past. Now it may revive due to the cut in rates,” says A. Balasubrahmanian, CEO, Birla Sun Life Mutual Fund.
If deposits rates come down, banks will be able to cut their lending rates as well. That’s something borrowers like Sumit Rohtagi (see picture) are anxiously waiting for. Though the Rs 6 lakh he has in the PPF will earn less, the Gurgaon-based finance professional is hoping that the interest on his Rs 53 lakh home loan would come down. Even a 25 basis point reduction in the home loan rate will shave off nine EMIs from his loan tenure.
Young investors like Rohatgi, who also invest in equity funds, debt funds and NPS and have large outstanding loans, will gain more if the RBI cuts interest rates. The bond market has already factored in a 25 basis point cut and the equity market could zoom if rates are cut.
Not good for senior citizens
However, the impact will be distinctly different for senior citizens and retirees who depend on income from their investments. “Senior citizens will be badly hit. While their income will come down due to lower interest rates, there won’t be any let up in their expenses,” says Kuldip Kumar, Partner and Leader-Personal Tax, PwC India.
In Delhi, 74-year-old Ranjit Rai Grover (see picture) is digging out the certificate of his bank deposits that offer him higher interest than the Senior Citizen’s Saving Scheme. “But these deposits will mature very soon. I want to break these investments and lock in at the 9.3% in the Senior Citizens’ Saving Scheme before the rate cut comes into effect,” he says.
With barely three-four days to go, it is a race against time for this senior citizen investor. However, he should also consider taxfree bonds and RBI Savings Bonds. The yields to maturity of tax-free bonds have come down to around 7.25%, but they are still a good option for senior citizens who are in high tax brackets and want to generate stable income. “These products don’t have put or call options, so investors can enjoy the fixed tax-free interest for the next 15-20 years,” says Vikram Dalal, Managing Director, Synergee Capital Services. “Since the yield is expected to go down in the coming months, investors must lap up tax-free bonds immediately,” says Gajendra Kothari, MD & CEO, Etica Wealth Management.
Another option is the RBI Savings Bond. “Since the 8% RBI Savings Bond pay interest on half yearly basis, the yield works out to be 8.16% and therefore, is a good option for senior citizens who are not in the tax bracket,” says Dalal. This six-year product also offers a cumulative option.
Investing in debt funds
Though banks will eventually cut deposit rates, investors can lock into long-term fixed deposits and recurring deposits right now. However, they are not very tax efficient instruments. A better option would be to go for debt funds because the income is taxed at a lower rate after three years. If an investor puts Rs 10 lakh in a debt fund and derives a monthly income from the corpus after three years, the effective tax paid on the withdrawal in the fourth year (2018-19) will be significantly lower at 1.12% compared to 10-30% on the income from a fixed deposit. If this investment is made before 1 April, he can also avail of indexation benefit for 2015-16. Then the effective tax rate in 2018-19 will be only 0.34%.
Investors can also consider fixed maturity plans (FMPs) from mutual funds. A lot of FMPs are currently open. “Investing into three-year plus FMPs (1,110 days) is good option now, as the four year indexation makes it tax efficient,” says Amol Joshi, Founder, Plan Rupee Investment Services.
LONG-TERM DEBT FUNDS STAND TO GAIN FROM RATE CUT
If interest rates fall as expected, the long-term gilt and income funds should continue to generate good returns.
Girl child scheme
Despite the recent rate reduction, the Sukanya Samriddhi Yojana continues to be the best option available now. “A tax-free return of 8.6% is good, so parents who have daughters below 10 should first consider the Sukanya scheme for their longterm goals,” says Alam. This scheme is also eligible for deduction under Section 80C.
However, there is a Rs 1.5 lakh annual investment limit in the Sukanya scheme. If you want to invest more, the Voluntary Provident Fund (VPF) remains a good option for the salaried class. The proposed tax on EPF corpus has been rolled back. Even if it is introduced in later years, the tax will be with prospective effect and existing investments will be spared. However, experts warn that EPF rates will also come down eventually. This is because the current rate fall is going to affect the
instruments EPF will be investing in. “Since EPFO has to invest 50% of the corpus in G-Sec, 45% in private and PSU companies with rating of at least AA and 5% in equities, it is not correct to expect more than 8.25% interest in the coming years,” says Dalal.
What of the PPF?
As mentioned earlier, the PPF will now become a truly market linked product with a quarterly reset of the rate. The PPF has beaten inflation in the long term, generating an average return of 9.17% in the past 20 years when inflation has averaged 7.17%. Even after the reduction to 8.1%, it is higher than the inflation rate of 5.9%. In other words, there is no need for investors to avoid PPF altogether. “PPF still remains an attractive option because it offers.