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With the repo rate increase, investors can expect a better deal as the Reserve Bank has reversed the trend of rock-bottom interest rates
With the repo rate increase, investors can expect a better deal as the Reserve Bank has reversed the trend of rock-bottom interest rates
The Reserve Bank of India’s decision last week to convene a surprise meeting of the Monetary Policy Committee and increase its repo rate from 4% to 4.4% triggered turmoil in the stock markets. But this is good news for fixed income investors.
It shows that RBI and the MPC are finally willing to reverse their three-year old policy of keeping interest rates at rock-bottom levels to help businesses and borrowers survive the pandemic. Savers and investors can look forward to a better deal on their fixed income products in the year ahead.
With the upcycle just beginning, interest rates in India may still have a long way to go. Before it declined to the multi-decade low of 4%, India’s repo rate used to be at 6% in 2018. It even went as high as 8% in 2014-15. Right now, with RBI walking a tightrope between inflation and growth, market experts believe that repo rates could move up by another 75-100 basis points (bps) over the next one year to 5.15-5.4%. Though it is the official policy rate, the repo rate by itself has little relevance to savers or investors. It is simply the rate at which banks borrow short-term money from RBI whenever they need liquidity.
So, if you’re a fixed income investor, it’s more useful to know what has been happening and what is likely to happen to interest rates on the investment options you use regularly, so that you can make appropriate choices. Here goes:
Bank FDs
Though RBI’s repo rate moves are supposed to send out signals for banks to follow, bank fixed deposit (FD) rates are usually quite slow to respond to RBI moves, especially when there is an increasing trend.
So, despite all the action on market interest rates in the last one year, SBI’s FD rate for one to two years for instance, has barely moved from 5% in January 2021 to 5.1% now (last revised in February 2022). FD rates for 2-3 year tenures have risen from 5.1% to 5.2% and those for 3-5 year tenures from 5.3% to 5.45%. Private sector banks such as IndusInd offer a slightly better deal on rates at 6-6.5% for terms from 1 to 5 years and small finance banks such as Equitas offer 6.1-6.75% for similar terms.
But bank FD rates today compare quite poorly to market interest rates and are quite likely to be revised upwards in the next one year. If you are a bank FD investor, it makes sense to stick to the lowest possible tenures right now, say six months to a year. This can help you move on to far better rates when banks decide to catch up with the RBI and the markets.
Post-office schemes
The interest rates on post office schemes such as Post Office Time Deposits, Monthly Income Account, National Savings Certificates (NSC), Senior Citizens Savings Scheme (SCSS) and PPF are reset every quarter by the government.
For the current April-June quarter of 2022, post office time deposits offer 5.5% for 1 to 3 years and 6.7% for 5 years. The Monthly Income Account offers 6.6% and the NSC, 6.8%. SCSS offers 7.4% while PPF is at 7.1%.
All of these rates are better than comparable rates for bank FDs. The rates on post office instruments are supposed to be linked to market yields on government securities of different tenures.
Therefore, given that market yields on government bonds have gone up sharply in the last six months, the rates on post office schemes are overdue for upward revision.
But in order to shield savers from the very sharp fall in market interest rates, the government had not reduced the rates on these schemes for the last two years. When rates on post office schemes are raised, it increases the government’s borrowing costs because the proceeds of these schemes are used by the Centre.
Therefore, you can expect interest rates on post office schemes to be raised in the next one year, if the rate upcycle continues. However, the hikes may not materialise immediately. If you are looking to invest in post office schemes, avoid the long-term schemes that lock in your money for five years plus such as the Monthly Income Account, NSC, SCSS and so on; it is best to postpone your investment for a quarter or two until better rates kick in.
If you are looking to invest in pension or annuity schemes, it would be best to put off the investment in the expectation of better rates.
Government bonds
With the RBI recently allowing investors to open RBI Retail Direct Gilt accounts, ordinary investors have the opportunity to participate directly in government bond auctions. The good news for retail investors is that yields in the government bond market tend to be very quick to respond to inflation and other market cues. In fact, in the last one year, yields on these bonds have run up much ahead of bank FDs and post office schemes. The accompanying table shows that after rising by 130 to 200 basis points, current yields on the one-year government security (gilt) trade at 5.77%, 3-year gilt at 6.92%, 5-year at 7.27% and the 10-year at 7.47%. These are very attractive rates for the safest bonds in the market, which are centrally guaranteed. Regular-income seekers can invest in these auctions if they are willing to lock in their money until the maturity of these bonds. Here too, it would be safer to invest in the 1-5 year bonds to begin with, and move on to longer-term bonds as rates move up further.
Mutual funds
Mutual funds, unlike the above instruments, deliver returns both from the interest received on bonds they own and gains on bond prices. Most debt funds outperform other options when rates fall. But as interest rates increase, declines in bond prices cause NAV losses in debt mutual funds. The longer the term of the bonds the debt fund owns, the more the dent to the NAV.
Therefore, investors in mutual funds today would be better off sticking to debt funds that invest in very short-term bonds of less than a year. Ultra-short duration, low duration funds and floating rate funds are the better options.
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