Within 24 hours of announcing a sharp cut of 40-110 basis points in interest rates on various small savings schemes, the government withdrew its order on Thursday. Many feel, however, that the rollback could be temporary and the rates announced on Wednesday are an indication of where they are headed. Investors should take note of the direction in which interest rates on small savings schemes and bank deposits have been moving, and accordingly take a long-term call.
Newsletter | Click to get the day’s best explainers in your inbox
What did the government announce, and what changed?
In Wednesday’s announcement, interest rates were lowered from 7.1% to 6.4% on public provident fund (PPF), from 6.8% to 5.9% on National Savings Certificate (NSC), from 7.6% to 6.9% on the girl child savings scheme Sukanya Samriddhi Yojana, and from 4% to 3.5% on small savings schemes, for the first quarter of 2021-22.
The small saving rates are linked to yields on benchmark government bonds, which have fallen over the last one year as the Reserve Bank of India has cut rates to support the economy.
The rollback came within 24 hours. Finance Minister Sitharaman tweeted: “Interest rates of small savings schemes of GoI (Government of India) shall continue to be at the rates which existed in the last quarter of 2020-2021, ie, rates that prevailed as of March 2021. Orders issued by oversight shall be withdrawn.”
How should one read this?
Bankers say that while the government may have deferred the cut in rates for now, the writing is on the wall. “At a time when housing loan rates are under 7%, one can’t expect fixed interest rates of around 7-8% on small savings instruments,” said a banker who did not wish to be named.
Many feel the government could announce the reduced rates again, either over the next couple of months with retrospective effect from April 1, 2021, or in the next quarter beginning July 1.
Economists also say that since the central government uses the small savings fund to finance its deficit and is looking to reduce the cost of deficit financing, it will go for a reduction in small savings rates, and that could happen on for the next quarter.
While a cut in rates would mean that the government wants people to spend and provide impetus to the economy, this would lead to further rationalisation of fixed deposit rates by banks going forward, and would reduce returns further. A lower rate would mean negative real rate of return on most debt instruments as inflation is hovering around 5%.
Should you invest in small saving instruments while the rates are higher?
Financial advisers say that there is not much one can do as the government is expected to announce the cuts over the next few months. “The best that an investor can do is to invest in a high-interest-yielding small savings instrument that has a quarterly compounding frequency as in that case he/she will earn a higher rate for at least this quarter, provided the government does not announce the revised rates in May with retrospective effect from April 1,” said Surya Bhatia, founder, Asset Managers.
For instruments for which the interest rate is compounded annually, there is not much investors can do now. Even if the government announces a revision in rates after a quarter, the rates on such instruments will most likely be effective from April 1, 2021.
What should be your debt investment strategy for now?
As interest rates are likely to remain low for some time, there is a sense that one should not invest in debt schemes for the long term. “One should not invest in long-duration schemes and should invest for 2-3 years. Once the yields go up, one can go for longer-duration funds or schemes,” said Bhatia.
Fund managers say debt investors can go for short-duration funds and actively managed duration funds. A fund manager who did not wish to be named said as repo rates have come down from 5.15% to 4% since December 31, 2019, the yield for 3-year AAA-rated corporate bonds (CB) has come down from 6.8% to around 5.2%, which means there has been a meaningful transmission in high-quality papers. However, in the same period, while the yield on 3-year AA-rated CB has risen from 7.85% to 7.96%, the yield on 3-year A-rated CB has come down from 9.47% to 9.21%.
“Investors can go for active-duration management strategy and look at short- to medium-duration funds and dynamic-duration bond funds for better return on debt portfolio,” said a fund manager.
However, as debt investments have turned unattractive because of low interest rates on fixed deposits and other instruments too, experts say equities look even more attractive as the long-term compounding benefit will only increase the gap.
If you invest in an equity scheme for the next five years and it generates even a modest premium over a debt investment, it will generate a significantly higher return on account of compounding and being more tax-efficient.
How are rates determined, and how does cutting them help the government?
Interest rates on small savings schemes are reset on a quarterly basis, in line with the movement in benchmark government bonds of similar maturity.
The yield on a 10-year government security, for instance, has dropped from around 6.8% in April 2020 to around 6.1% now. For the last one year, yields on benchmark government bonds have ranged between 5.7% and 6.2%. This provides the government the leeway to cut rates on small savings schemes in future. While a lowering of interest rates will help the government reduce interest costs, it would hurt investors, particularly senior citizens and the middle class. Small savings have emerged a key source of financing the government deficit, especially after the pandemic led to a ballooning of the government deficit, necessitating more borrowings. In the 2020-21 Revised Estimates, the government estimated it would raise Rs 4.8 lakh crore through small savings, against the Budget Estimates of Rs 2.4 lakh crore. In 2021-22, borrowings through small savings have been pegged at Rs 3.91 lakh crore. Lower rates on a higher base of central government debt helps keep borrowing costs under check.
How has inflation moved, and do banks cut lending rates in line with cuts in deposits?
The latest retail inflation data showed the headline number rising to a three-month high of 5.03% in February from a 16-month low of 4.06% in January. In light of this, some of the small savings products may not yield much in terms of real interest rates. Wednesday’s announcement came in the backdrop of a similar reduction in overall deposit rates by commercial banks.
During March 2020 through February 2021, medium-term deposit rates fell by 144 basis points, as per the latest RBI data. The weighted average lending rate on fresh rupee loans sanctioned by scheduled commercial banks have witnessed a drop of 112 basis points since March 2020. The drop in deposit rates has, however, been faster when compared with lending rates. The RBI noted that the adjustment in deposit rates accelerated in the aftermath of Covid-19 on account of persistent surplus liquidity amid weak credit demand.
During the same period, the one-year median marginal cost of funds-based lending rate (MCLR) softened cumulatively by 94 bps, indicating reduction in overall cost of funds.