Portfolio Ideas. Why PPF is attractive despite rate cuts

The government has cut interest rate on public provident fund (PPF) by 0.60 percentage points to 8.1 per cent. This rate is effective for the first quarter of 2016-17 (April-June).

It is moot as to whether there would be more such rate cuts in the future. The question is: Should you continue to invest in PPF despite the rate cuts?

As you will see, PPF offer certain advantages that make it an attractive investment despite rate cuts.

Bond investments are an integral part of the portfolio that you create to achieve any life goal. Agreed, stocks offer you higher expected return but that comes at a higher risk.

At the extreme, if you have an all-stock portfolio, you have to wait till the end of the time horizon to see if your portfolio has enough money to achieve your life goal. On the other hand, if you have an all-bond portfolio, you will know the end-of-the-horizon portfolio value even at the time of investment. This is because the bonds you invest will have finite life and pay fixed cash flows.

Of course, in real life, you cannot have an all-bond portfolio because expected return on bonds is lower than that on equity. Lower bond returns force you to make higher capital contributions to achieve your life goal.

So, your portfolio should have an appropriate mix of bonds and equity — bonds provide the floor or stable cash flow and equity the upside. It is in this context that you have to view PPF. For the purpose of our discussion, bonds refer to all interest-bearing products, including PPF and bank deposits.

You receive tax-free interest income on your PPF investments. A 10-year bank deposit, for instance, will offer less than 6 per cent post-tax returns. So, despite rate cut, PPF could offer higher post-tax return than other taxable bond alternatives.

What about tax-free bonds issued by companies such as NHAI? Of course, such tax-free bonds are attractive, though lower than the PPF rate. Importantly, you can invest large sums of money in such bonds, unlike PPF where the maximum investment is capped at ₹1.5 lakh per annum.

But the problem is that tax-free bond offers are often oversubscribed; your allotment will be proportional to the application amount.

That is not the case with PPF. So, to meet your annual bond allocation, exhaust your PPF limit first and then allocate the rest to tax-free bonds and taxable bank deposits.

The second reason why PPF is attractive despite the rate cut is to do with its structure. You cannot easily withdraw the money from your PPF account.

This creates “sticky” retirement savings for you; higher liquidity could tempt you to withdraw money to meet other short and medium-term goals such as buying a house.

In addition, you can invest in PPF every month through an auto-debit from your salary account. This creates disciplined savings and helps you moderate your present bias. Otherwise, you are likely to spend the amount.

You should invest in PPF even if the rate is cut further. Why? If the government cuts PPF rate further, it is highly likely that interest rates on other bond instruments would also decline. Because of tax benefits, post-tax return is still likely to be higher compared with other instruments, unless the rate cut on PPF is steeper.

Whether the government will impose a steep rate cut on PPF is moot.

So, as long as PPF offers higher post-tax return compared to other retail bond investments, you should exhaust the maximum investment cap. When government cuts rates, compare PPF with, say, bank deposits, and not with interest rates offered in the past.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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