Bank deposits turn sour for savers

Since the beginning of the current calendar year, the Reserve Bank of India has undertaken several initiatives to bring down interest rates. It cut the repo by 125 basis points to 6.75% so far. Under repo, banks get funds from the RBI at 6.75% against government securities. The RBI's contention has however, been that banks need to to pass on 60 bps cut to borrowers. The RBI on several occasions have expressed its desire that the entire benefit of repo rate cut need to be passed on but banks have been reluctant as their cost of funds garnered in deposits remain high and they run the risk of a shrinkage in net interest margins. One year deposit rates which averages around 8% need to be brought down before cutting lending rates any further. They did bring down home loan rates to 9.5-9.7% from 10-10.25% after some persuasion from RBI. For any further cuts now on two conditions need to be fulfilled: i) inflation rates need to soften from the present 5.4% and ii) cost of funds raised through deposits need to be re-priced lower.

New deposit rates of banks for one year has already been revised downwards to 7.5%, which is taxable for savers. Depositors, post-tax, earn 4.75%-5% in returns, barely managing to stay afloat with positive returns against an inflation rate of 5.4%. The RBI's view on inflation by March 2016 is 5.8%.

What does a higher inflation mean to savers?
Inflation is a reduction in purchasing power of goods per unit of money. So when inflation is on an upswing, as the case is currently, and if it reaches RBI's estimate of 5.8%, there is every likelihood that bank deposits could yield negative returns. In other words, given the current rate of return on bank deposits, post tax, of 5%, savers were likely to end up with capital erosion.

Risk of bank deposits in a rising inflation rate scenario
There are two factors to bear in mind in such an environment; one, the rate of interest, which is now getting re-priced lower and second, the tax liabilities on interest income. Both the factors go against savers and it would be wise to scout for investments that will yield a gross return of at least 12.5% annually so that post tax, one remains hedged against inflation with a net return of 7.5%.

Options available for investors
Public sector undertakings keep tapping the market with various tax-free bond issues that eventually get listed on the bourses.
About a week ago, the National Highway Authority of India, which comes under the Ministry of Road Transport and Highway, raised Rs 10,000 crore through tax-free bonds of 7.6%. The paper now trades in the secondary market at an yield of 7%.
These tax-free government bonds come handy especially at a time when investments like real estate and gold have been on the decline. However, the only drawback of such investments is the liquidity and the interest received that needs to be re-invested in either a taxable instrument or a tax-free instrument for getting the benefit of compounding. In this case the tax free instruments may not be available all the time to deploy the interest rate earned. Besides exit options may be restricted due to the liquidity factor unless one agrees to a price at a slight discount.
Primary investors certainly stand to gain, more so, in a falling rate scenario where bond prices soars and offsets the interest rate dip thereby pushing up the net asset value. However, most retail investors may not know how to go about liquidating their assets and quite often end up paying a huge cost of liquidation.

Investing in Government bonds
Ten-year government bonds currently offer an yield of 7.77% (7.93% annualised), 30-year gives 8.1% (8.24% annualised) while one year treasury bills return 7% all of which is not feasible when the taxes are factored in along with the current inflation rate.
The above mentioned options are explored only when interest rates are poised downward. In such a scenario capital appreciation comes to the aid and offsets the fall in interest rates which again is largely on account of several factors the key being easing inflation rate and liquidity. The longer the maturity the steeper the price appreciates. Typically fund managers have the wherewithal to predict rate movements.

Options under the present conditions
Given the above mentioned 10-year yield of 7.77%, when compounded, effectively works out to be ~8%. Over a ten-year horizon, Rs 1,00000/- more than doubles to Rs 2,15,900. In the short term, of say three years, the credit quality is good as mutual funds often opt for papers that are high yielding. Fixed income schemes of mutual funds are able to churn portfolios between short and long term depending upon the views on interest rates and generate excess returns.

(Next week: Investing in equity funds)