Think short term
Before you lock in your money in a fixed deposit, keep in mind that the repo rate might be hiked further. Though inflation has moderated, it is still above the RBI’s tolerance level. Many analysts believe there is room for another 35-50 bps hike in the repo rate. If that happens, bond yields will also go up. Investors should therefore go for short-term deposits of 12-15 months instead of locking in for the long term. More importantly, assess the fundamentals of the institution before you invest. If investing in a bank deposit, make sure the bank has a sound backing. Some banks, especially cooperative banks, offer very high interest but may not be able to repay your money. Similarly, check the credit rating of the NBFC before you take the plunge.
Small savings and RBI bonds
Rising bond yields is also good news for investors in small savings schemes and RBI bonds. The interest rates of small savings schemes are linked to the yields of government securities of the same duration. However, this rule has not always been followed to the T. The benchmark 10-year bond yield rose 140 basis points from 6.04% in June 2021 to 7.46% in June 2022. But the interest rates of small savings schemes were not hiked. Even if small savings rates are not hiked, they will at least not be cut. If small savings rates stay elevated, investors in the RBI floating rate bonds also stand to benefit. The interest rate of these bonds is linked to that of NSCs. They offer 35 bps more than NSCs. The prevailing rate of NSCs is 6.8%, so the RBI floating rate bonds are offering 7.15%. If the NSC rate is hiked to 7%, the interest rate of these bonds will go up to 7.35%, which is comparable to the deposit rates of banks.
Debt funds look promising
The past one year has not been very good for debt funds, especially gilt funds and long duration schemes holding very longterm bonds. With bond yields shooting up by more than 100 basis points in the past one year, long term bond funds have delivered measly returns of 2-3%. Even shortterm funds, that are not so badly hit by interest rate movements, gave less than 4%. However, this doesn’t mean investors should shun debt funds now. In fact, this is the time to get into these funds because there is limited upside in bond yields. Bondyields may start declining if the inflation is tamed by the interest rate hikes and other policy measures.
If that happens, long duration and gilt funds can give good returns. While debt funds are subject to volatility because they are marked-to-market, they score over fixed deposits in the long term. While interest from fixed deposits is fully taxable at the normal rate, the gains from mutual funds are taxed only at the time of redemption. Also, if held for more than three years, the gains from debt funds are taxed at 20% after indexation benefit. Indexation takes into account the inflation during the holding period, and accordingly adjusts the purchase price upwards to reduce the tax. During times of high inflation, indexation can reduce the tax to zero.
Best of both worlds
The prevailing elevated bond yields mean that investments in target date funds can be very rewarding. They offer investors everything they look for in a fixed income instrument. If you want certainty of returns, the flexibility to withdraw any time and also the benefit of lower tax rate, target date funds are for you.
Unlike open-ended mutual funds, these schemes have a maturity date. They invest in bonds and hold them till maturity, thus assuring investors a certain return on investment. The yield to maturity (YTM) of the fund is the indicative return an investor will get at the end of the fund’s tenure. Right now, many target date funds have YTMs of more than 7%. Given the high inflation, the post-tax return from a target date fund with a YTM of 7.3% and held for more than three years can be as high as 7%.