Make the right moves

Arun Jaitley has made all his moves as the new Finance Minister. It is now over to you — the fixed income investor. Here are four themes to bet on.

Interest rates have peaked The big event, which had bond markets on the edge, is finally over. Sticking to the fiscal deficit target of 4.1 per cent for 2014-15, the Finance Minister has reiterated that this Government will strive to borrow less. This may ease inflationary pressures and give wiggle room for the RBI to effect rate cuts over the next year or so.

While it is clear from the RBI’s policy stance that rate cuts are likely to come about only when inflation recedes, the Finance Minister has succeeded in warding off sharp increase in interest rates. There are now clear signs that interest rates have peaked. This is a good time to lock into higher rates before the tide turns. If you have been waiting on the sidelines, hoping for better rates on fixed deposits, now is the time to invest.

Taxes rejigged The Budget has given a new lease of life to the good old fixed deposit by removing the tax advantage that fixed maturity plans and short-term debt funds enjoyed for one- to three-year investments. So if you wish to park your money for one-to-three years and prefer predictable returns, FDs are superior to debt funds.

Earlier, gains made on debt funds held for more than one year were treated as long-term capital gains, and taxed at a 10 per cent flat rate. This tax benefit helped short-term debt funds deliver better post-tax returns compared with FDs of similar tenure. In the case of FDs, the interest is clubbed with income and is taxed according to the specified slab rates.

But now, the tenure for claiming long-term capital gains tax on debt funds has been increased to three years. This means that capital gains made on debt funds held for less than three years will be taxed at 10-30 per cent, similar to FDs. This has come as a huge setback for fixed maturity plans (FMPs). Fund houses normally issue FMPs with a tenure of slightly more than a year so that investors can enjoy the benefit of lower long-term capital gains tax.

With the tax differentials gone, the case for investing in one-to-three years FMPs is weak. With respect to open-ended debt funds, you can opt for them based on returns (ability to outperform markets) and liquidity. Banks score higher on safety due to deposit insurance.

The average rates for bank deposits of one- to three-year tenure have gone up by about 25 basis points in the last one year. Given that rates are unlikely to decline immediately, depositors will continue to enjoy attractive rates for some more time.

At present, banks offer 9 per cent interest on three-year deposits on average. The highest rate offered on deposits of this tenure is 9.4 per cent by DCB. Other banks, such as Karur Vysya Bank and Laxmi Vilas Bank, offer 9.25 per cent.

Short-term debt funds and FMPs have delivered 9-10 per cent annual return in the past. Hence, the post-tax return for both options has worked out to be the same, while banks are certainly the safer option. You can also look to lock into attractive rates offered for FDs by NBFCs and companies too. AAA-rated fixed deposits from the likes of Gruh Finance, HDFC (Platinum) and LIC Housing offer 9.25-9.5 per cent for similar tenure. Mahindra & Mahindra Financial Services offers 10.25 per cent.

Long bond strategy With the equity market reviving, justifying risky bond investments has just become more difficult. But if you are a risk taker, betting on a bond price rally over the next year is a possibility. Be sure to pick funds that performed consistently across rate cycles.

The Budget has sought to tax long-term gains arising out of debt funds at 20 per cent with indexation. Thus if you hold debt funds for over three years, your post-tax returns may be better than your bank deposits. Gilt and income funds have delivered 9-11 per cent annually in the past, with returns going up to as high as 14 per cent in a falling rate cycle. Compared with post-tax returns of bank FDs, this is attractive. The best rate offered by banks on deposits of this tenure is 9.25 per cent.

However, if you are in the 10 per cent tax bracket, your fund should deliver at least 30-40 basis points higher than the best bank FDs to justify the market risk you take on.

Given the uncertainties surrounding interest rates, dynamic bond funds are a good option to consider. Dynamic bond funds have the flexibility to switch between short-term and long-term debt instruments, depending on the fund manager’s view on interest rates. Some of the top performing dynamic funds have delivered returns upward of 12-14 per cent in the best of times and managed a 9-10 per cent return even in a rising rate scenario.

If you are a risk taker and prefer gilt or income funds, be sure to pick out funds that manage their duration actively. A bond price rally in long-term bonds over the next few months can come with sharp swings in returns.

Small savings are back Peaking of interest rates also means that it is a good time to pump more money into small savings schemes. As the interest rates on these schemes are pegged to the yield on the 10-year G-Secs at the beginning of every fiscal, if rates were to fall in the next one year, it will mean lower rates for small savings schemes as well.

Moreover, the Budget has given a boost to small savings schemes this time around. To start with, it has raised the limit you can invest in public provident fund (PPF) from ₹1 lakh to ₹1.5 lakh. The principal invested under small savings is exempt from tax under Section 80C. With the Budget increasing the deduction limit under Section 80C from ₹1 lakh to ₹1.5 lakh, and the interest of 8.7 per cent on PPF also completely tax-free, the entire contribution to the PPF qualifies for a tax deduction.

The five-year NSC, with an 8.5 per cent interest rate, is also a good option, yielding better returns post-tax than comparable bank deposits. Remember, interest earned on NSC, which is accumulated, is eligible for tax benefits if there is room under Section 80C. The 10-year NSC offers an interest rate of 8.8 per cent.

The Budget has proposed to launch National Savings Certificate, with insurance cover, which will provide additional benefits for the small saver. However, the details are awaited.

Also, in the small savings space, there are plans to introduce a special small savings instrument to cater to the requirements of the girl child’s education and marriage. If you want to park your money for 10 years, both the 10-year NSC and PPF fit the bill, as there are no comparable instruments offered by banks currently.

Also read : >Don’t sit on the fence

>Build your property portfolio

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