Beat shrinking deposit rates

With over 125 basis points cut in the repo rate in 2015, some banks have already cut rates but they are under pressure to reduce them further. This can happen only when banks reduce the rates on fixed deposits.

In the last quarter of 2015, banks have already started paring down interest rates by a half or one per cent on fixed deposits. A year ago, an FD with one-five year maturity period used to yield an annual interest of 8-8.5 per cent. Today, FDs with similar maturities yield around 7.5 per cent interest.

RBI has also asked the government to bring down interest rates on small savings schemes like PPF, NSC, Kisan Vikas Patra (KVP), etc. So expect your money parked in these instruments to earn up to a half per cent lower from April when the rates come up for revision.

So many depositors are now searching for alternative risk-free investment options, which give a better return than FDs and small savings.

Tax-free bonds The interest earned on these bonds is tax-free and therefore, they are attractive investment options for individuals in the higher tax bracket. This holds true despite the fact that the coupons on tax-free bonds are lower than the yields on government bonds of similar maturities.

The yield on 10-year government bond is around 7.6 per cent and therefore, one can expect the interest (coupon) on tax-free bonds to be around seven per cent. A bank FD with 5-10 year maturity is available at 7.5 per cent. However, after taxes, it would be lower than that of tax-free bonds. The post tax-return from an FD earning 7.5 per cent annual return is 6.7 per cent for an individual in the 10 per cent income tax bracket, six per cent for someone in the 20 per cent tax bracket and 5.2 per cent for a taxpayer in the 30 per cent tax bracket.

A tax-free bond with seven per cent coupon is, therefore, a much better option than an FD earning 7.5 per cent interest.

Public Provident Fund Despite the likely cut in interest rates of small savings schemes, PPF would continue to be one of the most tax-efficient investment options.

Even if the interest on PPF is reduced from the current 8.7 per cent to 8 per cent, the effective return would be much higher because not only is investment in PPF eligible for income tax deduction, but also, the interest earned is tax-free.

For example, the effective yield on PPF earning eight per cent average interest throughout its tenure of 15 years would be 12.2 per cent for a person in the 30 per cent tax bracket, 10.6 per cent for a person in the 20 per cent tax bracket and 9.2 per cent for one in the 10 per cent tax bracket.

Debt mutual funds Mutual funds offer a variety of options that help investors benefit from the future rate cuts as well as from existing high yield opportunities. There are two strategies that investo-rs can benefit from — long duration funds and locking investments in high-yield accr-ual funds.

Long duration funds As fall in market interest rates leads to increase in bond prices, funds that invest in long maturity bonds — usually government bonds and long-maturity corporate bonds — gain from increase in the price of the bonds that they have in their portfolio. This is a higher-risk strategy, as long duration funds are more responsive to interest rate changes. Long-tenure income funds and gilt funds are examples of long-duration bonds. In times of falling interest rates, these funds can generate double-digit returns. However, invest-ors must bear in mind that returns from debt funds are not tax-free. If redeem-ed within three years of investment, any capital gains from debt funds is taxed in the same way as the interest ear-ned on FDs is. However, if it is redeemed after three years, the capital gains are taxed at 20 per cent after adjusting the investment for inflation.

High yield accrual funds If your concern is falling interest rates in future, lock some of your investments in the few high-yield opportunities still available in the market through accrual funds. These funds usually invest in high yield bonds and hold these bonds till maturity, thus negating any impact of change in interest rates. Typically, these are short-term bond funds. Ultra short-term funds and short-term income funds are such funds where investors can invest now for six to 18 months to reap benefits of high yield opportunities still available in the market.

The real rate of return Investors wary of falling interest rates on bonds and FDs must remember that absolute rate of return does not give the right picture. They should always look at the real rate of return to know if their investments are growing or not. Real rate of return is arrived at subtracting consumer inflation from the after-tax rate return.

If inflation is five per cent and the after tax-return from FD or small savings scheme is six per cent, then the real rate of return is one per cent. This is a much better than a scenario where an FD is earning 10 per cent interest and inflation is 11 per cent, which gives you a negative real rate of return of one per cent.