Better times await fixed-income seekers

With interest rates bottoming out and the economy picking up, opportunities for higher returns may open up

February 28, 2021 11:08 pm | Updated 11:08 pm IST

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Business risk and professional strategy profit concept - businessman walks big arrow as tightrope walker - isometric conceptual illustration for banner or poster

The spotlight has been on stock markets since the Budget presentation and subsequent stock swings have given palpitations to the adventurous. But this Budget had some significant signals for fixed income investors too, which have flown under the radar. If you’re a safety-seeking investor, you may have to rethink your choices.

What’s changed

If the last six years have been good to Indian equity investors, they’ve been very unkind to investors looking for assured returns. Between January 2015 and May 2020, Monetary Policy Committee (MPC) steadily pruned its policy rate from 8% to 4%.

In the past year, the RBI has pumped ample liquidity into the system to keep interest rates low in a bid to revive the sluggish economy.

This has meant three things for fixed income investors. Investors in bank fixed deposits (FDs) have seen a sharp decline in interest rates over the six-year period. Rates on 1-3-year FDs, that hovered at 8.5-8.75% in 2014-15, are now at 4.9-5.5%.

Interest rates on small savings schemes (SSS), which are pegged to market yields and reset at the beginning of every quarter, have seen a decline too, but not to the same extent as bank FDs.

Rates on 1-5-year post office time deposits were at 8.4-8.5% in April 2015 and are at 5.5-6.7% now.

Debt mutual fund (MF) investors have pocketed handsome returns in the last six years because such funds make returns from bond-price gains and not just from interest receipts.

When interest rates in the economy fall, prices of older bonds with higher rates soar in the market because they are much in demand.

For debt MF holders, bond-price gains have more than made up for lower interest accruals. As long-term bonds react more to rate changes, categories such as gilt, long-duration and dynamic bond funds delivered CAGRs of 8-10% in the five years from FY15 to FY21.

Set for reversal

But, with interest rates falling to their lowest levels in more than two decades over the past year, there are signs that the rate cycle may be due for a reversal.

Rising consumer price inflation since April 2020 has made it tough for the MPC to cut rates further, since May 2020. With the economy recovering faster-than-expected from COVID-19, there’s pressure on RBI to normalise the excess liquidity it has been pumping into the markets. While these factors set the stage for interest rates to bottom out, the Budget may have provided the trigger for them to finally move up.

In a marked shift from the past, the government, in this Budget, has announced that it would allow the fiscal deficit to shoot up to 9.5% in FY21 and remain at 6.8% in FY22. It also plans to continue with deficits above 4.5% until FY26, to stimulate the economy. It has indicated that it would review the 3% fiscal deficit target set in the FRBM Act, too.

The elevated deficits signal the market supply of government bonds will remain quite high for the foreseeable future. This has had bond investors demanding higher rates. The yield on the 10-year government security, the key benchmark for the Indian bond market, has shot up from 5.95% just before the Budget to 6.2% as of February 22. The 5-year government security has seen yields move up from 5.28 to 5.75%.

The 10-year AAA-rated corporate bonds are now at 6.8% against 6.4% just before the Budget, and could see further gains. While the RBI is still trying its best to keep government borrowing costs low by managing gilt auctions and buying gilts directly, the tug-of-war between the RBI and the markets is sparking sharp, two-way moves in bond prices.

All this affects choices for fixed income investors in four ways.

Bank fixed deposits

If you’ve been fretting over rock bottom interest rates from leading banks for your FDs, hang on just a few months more, as the rates may begin to move up. As economic activity picks up post-COVID-19, banks will have greater need of deposits to fuel lending and may offer better rates. SBI recently raised its 1-year FD rate marginally (4.9 to 5%). Other banks may follow suit.

If you’ve been thinking of switching to riskier deposits from NBFCs, small finance banks or smaller private sector banks for slightly better rates, don’t do it now. A few months down the line, leading banks and post office schemes may offer you those rates with less risk. If you wish to initiate new deposits, stick with the shortest possible tenure.

Small savings schemes

Interest rates on small savings schemes, reset every quarter, are officially supposed to be pegged to market yields on government securities (g-secs). Rates on the 5-year time deposit, National Savings Certificate and PPF are supposed to be 25 basis points (bps) higher than the 5-year g-sec and the Senior Citizens Savings Scheme is supposed to offer 100 bps more than it.

But in the past one year or so, the government hasn’t strictly followed this formula. It has kept SSS rates attractive by offering much more than the official 25-100 bps premium over g-sec rates. While the 5-year g-sec is now at 5.75%, the 5-year post office time deposit, NSC and PPF offer 6.7%, 6.8% and 7.1% respectively for this quarter (ending March 31).

Given this cushion, and the need to keep its borrowing costs low (SSS are also government borrowings), the government may choose not to immediately raise small savings rates. But their rates can go up later in FY22 if market rates continue to rise.

Given post-office schemes such as the 5-year deposit, NSC and PPF still offer considerably better rates than any of the deposits or other market options, you can still go for these options despite the lock-in periods.

Debt mutual funds

The honeymoon on high returns from debt MFs may be over. If you own debt funds, switch from those which invest in long-term bonds (gilt funds, long duration funds, dynamic bond funds) as they may deliver volatile returns or even capital losses. Best to stick with floating-rate funds or low-duration funds with an average maturity of up to six months.

Bonds and NCDs

Rising rates make it a bad time to buy long-term NCDs from PSUs or private firms in the secondary market or invest in new issues with 5/10/15 year lock-ins. An exception to this is the Government of India’s 7.15% per cent taxable floating-rate savings bond that is sold by RBI via leading banks, which will earn you better rates if market interest rates rise.

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