Riding Rising Rates

For retail investors in India,fixed deposits have always been an attractive investment avenue. It accounts for about 54% of the total household investment in the country and forms a major part of interest income for retired people. The central bank also guarantees deposits of up to R1 lakh,which means that an investor will get back the money in case the bank defaults. Investors get tax benefit under Section 80 CC of the Income-Tax Act for bank fixed deposits of five-year and above,but the interest earned is fully taxable and is added to the annual income of the individual.

In the last one year banks have been offering a host of fixed deposit products of different maturities. Moreover,in a scenario of rising interest rates,fixed maturity plans (FMPs) of mutual funds are also attracting retail investors for six,three,or even two years’ lock-in. FMPs with a maturity of over one-year have a tax advantage over fixed deposits,as fixed deposits are taxed as per the tax bracket applicable to the individual. Investors in FMPs have an option to pay tax on long-term capital gains at 10% without applying indexation,or 20% after applying indexation. Wealth managers say one should consider investing in FMPs only if the investor is willing to take some risk for tax-efficient returns.

Puneet Pal,debt fund manager at UTI Asset Management Company,says that yields have risen after the rate hike and now the markets are discounting further cumulative hikes of 50-75 basis points by RBI for the rest of the year.

“We believe that the short-term rates are at an attractive level from a risk-reward perspective and investors can look at short-term bond funds with a six-months to one-year horizon,where they have the potential to deliver high returns,” he advises.

Pal adds that the ideal time horizon should be one year and above and investments in debt mutual funds on a tax-adjusted basis will offer better returns consistently over a period of time. “So,considering all the factors,it makes better investment sense to put one’s money in debt mutual funds than fixed deposits,” he says. Analysts say the rise in yields will impact returns of long-term funds because of its inverse relationship with the price of bonds,and that investors should look at longer-maturity term deposits once interest rates stabilise.

Advantage savings deposit

The interest rate on savings bank deposits,which is a hybrid product combining features of both a current account and term deposit account,has remained unchanged at 3.5% per annum since March 31,2003. In fact,the RBI from July 1977 had fixed the interest rate on savings deposits with cheque facilities at 3% and 5% for savings bank accounts without cheque facilities. But the credit policy the next year merged the two accounts into a single savings account as depositors were opening multiple accounts and fixed the interest rate at 4.5%. In April 1992,the interest rate on savings deposits was fixed at the highest level of 6% per annum. But thereafter,the central bank has progressively reduced the interest rate on this account,which came down to as low as 3.5% in March 2003.

Savings bank accounts form a large part of the deposit base for public,private and foreign sector banks. RBI data show that around 22% of the total deposits of the banking industry is parked in savings accounts.

Public sector banks have stipulated a minimum balance of R1,000 for metros,urban and semi-urban areas,irrespective of the cheque book facility,and R500 for rural areas with cheque book facility. However,private and foreign banks have a higher balance requirement. The charge for non-maintenance of minimum balance by public sector banks varies from R20 to R225 for urban areas and R20 to R100 for rural areas for every quarter. For select private sector banks,it ranges from R750 in urban areas to R500 in rural areas every quarter.

Analysts say that after the recent interest rate hike on savings bank account,banks will be forced to revise upwards the penalty for non-maintenance of minimum balance and charge higher fees for cheque books,duplicate account statement facilities and ATM withdrawals. At present,some public sector banks charge R1 to R3 per leaf for additional cheques beyond the stipulated 25 to 50 cheques per year. However,some private sector banks do not have any limit on the number of cheques to be issued to account holders.

Though the half a percentage point increase in savings bank accounts is a positive development for retail investors who were getting negative returns from the December 2004 to December 2010,except for a brief period of March to September 2009 when the headline WPI inflation turned negative. The central bank is working towards freeing the administered rates,which will eventually increase the cost of funds for banks.