With a possible dip in Interest Rates, Consider Investing in Debt Funds

Smart-Investments

It is too early to predict the real impact of demonetisation. But, some short-medium-term predictions are possible. For instance, the impact on the real estate sector is already being felt. Land transactions will experience a huge slump and will take years to recover. Yet another prediction that can be made with reasonable certainty is that we are going to witness a steady decline in interest rates.

A positive fallout of demonetisation is the huge flow of deposits into the banking system. Before demonetisation, the Indian banking system had total deposits of around Rs. 10 lakh crore. This has swelled to around Rs. 12.5 lakh crore by mid-December and is likely to touch Rs. 14 lakh crore soon. A part of this will be withdrawn when restriction on money withdrawals are lifted. Even then, the banking system will be left with huge funds, which it will be forced to lend. Also, the higher proportion of CASA (Current Account, Savings Account) deposits with the banks will lower their cost of funds. This will facilitate better monetary transmission. Also, the RBI can be expected to cut repo rate in the next monetary policy review in February. It is reasonable to expect a fiscal stimulus in the coming Union budget. The RBI is likely to supplement Government’s initiative with a monetary stimulus by cutting policy rates. The decline in CPI inflation rate (from 6 per cent at the beginning of 2016 to 3.63 per cent by November) has created the right macro environment for the RBI to cut rates. In brief, interest rates are set to decline starting early 2017.

Decline in interest rates is good news for the economy since it provides monetary stimulus for growth. It is good news for housing and vehicle loan borrowers. But, it is bad news for depositors since interest rates on deposits will also come down. Therefore, what should bank depositors do?

Most households put money in bank deposits to get a regular and dependable return. Bank fixed deposits are the favoured asset class of large number of senior citizens. This group of savers should now consider other asset classes that yield better returns. Investment in debt mutual funds is an attractive investment option.

People who need superior returns can consider investing in debt funds. Debt funds yield good returns when interest rates are trending down. The superior returns are due to the rising price of bonds. People who need regular income may consider MIPs (Monthly Income Plans). These are debt funds that invest around 80 per cent of their corpus in high quality bonds and debentures. The balance 20 per cent is invested in blue-chip stocks that give superior returns in the long run. MIPs have given annual returns of around 10 per cent during the past six years. In future, returns will be lower, but will certainly be better than bank deposit rates.

Apart from yielding superior returns, debt funds are highly tax-efficient. The long-term tax rate (if held for minimum 36 months) is only 10 per cent without indexation and 20 per cent with indexation. Therefore, savers who depend on their interest income may consider switching a part of their deposits to MIPs or other debt funds that can yield superior returns.

(The author is Investment Strategist, Geojit BNP Paribas)