Investment options to beat dipping interest rates
It’s a hard time for many as interest rates continue to fall. The government has again to cut interest rates on small savings schemes like public provident fund, senior citizen savings scheme and Sukanya Samriddhi by 10 basis points for this quarter. Banks too have been cutting fixed deposit rates over the last two years. In the last one year, banks have cut deposit rates by more than 150 basis points, now fetching below 7 per cent per annum.
Also, since bank deposits are fully taxable, the post-tax returns for those in the highest tax bracket of 30 per cent works out to below 5 per cent which is too low to meet any financial goal. While fixed deposits provide safety of capital, they cannot be instrument for long-term wealth creation.
The central bank is likely to cut rates in August according to many economists as inflation has remained under control. The CPI on May 2017 (2.18 per cent) dropped to its lowest level since 2012, aided by the fall in food prices. The WPI inflation too has been on a near-steady decline since January 2017, having fallen from 4.26 per cent to 2.2 per cent.
Here’s what people can do with their savings:
1. Exhaust PPF Limit: The PPF is still the best investment instrument as it continues to offer a tax free return of 7.8 per cent for July-September quarter. One should, therefore, completely exhaust the limit of Rs 1.5 lakh per annum that PPF allows. Given that consumer inflation is down to 2.18 per cent, the real rate of return of PPF is still 5.62 per cent.
2. Invest in Sukanya Samriddhi Scheme: Like the PPF, the SSC too offers tax free returns and will offer 8.3 per cent for the second quarter. So if you have a girl child, exhaust the full limit of Rs 1.5 lakh in the SSS.
3. Increase allocation to Employee Provident Fund: The salaried class has an option to opt for a higher contribution towards EPF. The government had earlier given a nod to 8.65 per cent interest rate on EPF for 2016-17.
4. Move to debt mutual funds: Through debt mutual funds, you diversify your investments in commercial paper, bonds and government securities. The returns are market-linked and professionally managed. Debt mutual funds can be categorised either as liquid funds, short-term income funds, fixed maturity plans and long-term income funds. This categorisation is on the lines of tenure i.e. liquid and short term (0-1 year), medium (1-3 years) and long-term (more than three years).
If your timeframe is short, say one or three months or even a year, you can go in for liquid funds or ultra short-term funds. If your investment time frame is one to two years, go in for short-term funds. If your investment time frame is 3 to 5 years, alternative substitutes for bank FDs are income accrual funds or dynamic bond funds which are known to give decent returns.
Assuming that the Reserve Bank of India (RBI) cuts the policy rate in August, existing debt mutual fund investors would see the Net Asset Value of debt mutual fund schemes rise in sync with the fall in interest rates. There are three guidelines for evaluating investments – risk, liquidity and return.
According to Vidya Bala, head of mutual fund research at Fundsindia.com, “People should start allocating to income accrual funds which will give them capital appreciation and steady returns. Those who have already invested in dynamic bond funds and duration funds should continue to hold on to their investments.”
The returns generated from short-term debt funds are similar to the interest earned on fixed deposits, but taxation benefits help to earn a higher return if they are held for more than three years.
Those who prefer low risk options should move to income accrual funds and short-term debt funds. Besides generating superior returns, debt funds are also more tax efficient than fixed deposits. If you hold your investments in debt funds for three years, then you get an indexation benefit which will bring down your tax outgo. In a debt fund, long-term capital gains are taxed at 20 per cent after indexation, while short-term capital gains are added to income and taxed at the normal rate applicable to you. Thus, for those in the highest (30.9 per cent) tax bracket, instead of paying 30.9 per cent tax on the interest earned on a fixed deposit, the tax rate is 20 per cent in debt fund, which is further reduced by the indexation benefit.
Since inflation eats into returns, tax should only be paid on the real part of gains, which is the concept of indexation. If you withdraw from a fund three years from the date of investment, marginal tax rate will apply. But, if you withdraw after three years, investors have the option of paying long-term capital gains at the rate of 20 per cent with indexation benefit. There is also the option of paying a flat long-term capital gains tax of 10 per cent and investors can choose the most favourable option.
Invest a small part in gold which enjoys greater demand in a low interest-rate environment and loses its sheen when rates rise; so one could use gold allocation as a hedging strategy. Hence, depending on one’s risk profile and overall economic outlook, one can diversify portfolio by investing 5-10 per cent of the total investible corpus in gold.
Columnist: 
Falaknaaz Syed
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