Why FD Rates Are Dropping And What You Should Do

By BankBazaar | November 21, 2016

 

Why FD Rates Are Dropping And What You Should Do

The Rs. 500 and Rs. 1,000 notes ban has resulted in a cash crunch for many. To add to all the woes, here’s another bit of bad news. Banks have started slashing their Fixed Deposit rates. Many investors are fretting over this. Why are banks slashing rates now when the Reserve Bank of India (RBI) has not slashed rates recently? If all banks slash their Fixed Deposit rates, what are your options as an investor? We’ll tell you all this and more.

Why the slash?

The ban of the Rs. 500 and Rs. 1,000 notes has led to a large inflow of deposits for the banks. It is estimated that Rs. 4 lakh crore has flown into the banking system since the announcement made on November 8. Now, banks have to pay interest if all this money goes into Fixed Deposits. Unless banks find a way to deploy all the deposit money, through their lending business, it will be tough for them to pay high interest rates for the Fixed Deposits.

Don’t get it? Let us explain. A bank’s business is to lend money and get interest. At the same time, it will receive deposits and pay interest. Only when the interest received is higher than the interest paid, will the banks make profits. Also, only when the bank has lent all the money received, can it get income in the form of interest. This is precisely the reason why banks are slashing interest rates on Fixed Deposits. As long as deposits keep coming in, one can expect banks to slash interest rates.

What’s the way forward?

Up until now the Reserve Bank of India (RBI) has been telling banks to pass on the rate cuts to people. Now that the banks have actually started doing that, the RBI might think about cutting interest rates further. Here are some of the reasons why the RBI might cut interest rates sooner than later.

Losing steam – Inflation has been declining for the last 2 years, mainly on the back of lower fuel and vegetable prices. Inflation (as per the Consumer Price Index) has been averaging at about 4%-5% for the last one year. In October this year, inflation fell below the 4.5% mark year-on-year. This is a 14-month low. It was at 6.1% in July, the previous year. The Wholesale Price Index (WPI) has dropped to 3.3% during the same period. Food inflation has helped keep overall inflation at lower levels. There has been a good drop in prices of vegetables and pulses, leading to a fall in overall inflation. This year, the monsoon has been normal, which has helped maintain food prices. Inflation is expected to further ease up, due to the

The Wholesale Price Index (WPI) has dropped to 3.3% during the same period. Food inflation has helped keep overall inflation at lower levels. There has been a good drop in prices of vegetables and pulses, leading to a fall in overall inflation. This year, the monsoon has been normal, which has helped maintain food prices. Inflation is expected to further ease up, due to the demonetization drive.

This year, the monsoon has been normal, which has helped maintain food prices. Inflation is expected to further ease up, due to the demonetisation drive.

Another cut in the offing? – So far, the Reserve Bank of India’s (RBI) major focus has been on inflation. Once inflation falls, the RBI will look at cutting rates as early as the first quarter of 2017. But the amount of fall in rates is debatable. Some experts expect the RBI to ease around 50 basis points (one basis point is equal to one-hundredth of one percentage point) along with a Cash Reserve Ratio (CRR) cut as well. Some others feel that the interest rate cut will not be more than 25 basis points. The average expected fall could be pegged at 30 bps, but nothing can be said with certainty. This is because there are experts who believe that interest rates are not likely to fall.

Says Dhananjay Sinha, Head- Institutional Research, Emkay Global Financial Services, “International commodity prices have been firming up across board from food to metals, which has been reflected in rising core retail and wholesale inflation. Sharp INR depreciation coupled with rising commodity prices are likely to be inflationary at retail and wholesale level. Leaving aside the volatile vegetable inflation, overall CPI inflation witnessed an uptick in 86% (which is higher than last month’s reading of 84%) of its components according to our diffusion index. Further to this, demonetisation of currency notes, as well as GST are likely to have a significant impact on demand of high-end consumer durable items. Overall, we hold the view that RBI will not reduce the rates. With sufficient liquidity with the banks, they might undertake to sell OMO’s or hike CRR rates to absorb this surge in liquidity.

What if rates drop? – It will be best for investors to look at alternative investments such as bonds or bond Mutual Funds. Usually, when the interest rates fall, investors find that bond yields would also soften. But the best part is that bond yields might not fall significantly as they have already fallen quite a bit. The 10-year benchmark Government security hit an all-time low of 6.4% after the demonetisation drive. So, one might get better returns from the bond market or from a debt Mutual Fund when compared to returns from Fixed Deposits.

What’s the solution? – Given that inflation and interest rates are set to fall, you, as a fixed income investor, should do the following in the coming months:

Lock in – With interest rates likely to fall sooner than later, the first thing that you should do is lock in the available interest rates. It would be best for investors to lock in rates within the next 2 months. You could do this by buying into high yield corporate bonds, Government securities and Fixed Deposits. But, note that investment activity in India has been declining. This means that credit demand by corporates is low. That is why Government bonds are safe investment options for investors. You could pick up Government securities from the secondary market. The current yield of the 10-year benchmark security is 6.5% while a 365 days security would yield you 6.3%.

You could also consider corporate bonds with high yields. Yields could be as high as 8% for a rated corporate bond. However, note that corporate bonds are riskier than Government securities. Now that the yields are falling, prices might be high. Even a small fall could mean a significant increase in prices.

If you are willing to take that risk for extra returns, consider investing in long-term corporate bonds (AAA rated). Higher the ratings, lower the risks. You can also consider investing in bonds issued by top-notch Non-Banking Finance Companies (NBFC) within the 2-5 year tenure.

Alternatively, you could even consider corporate bonds with a put option (this is an option of selling the bond back to the issuer). This would help you sell the bond back to the issuer in case the company isn’t doing well or has been downgraded by credit rating agencies.

Tax-free bonds are another great option. It is expected that tax-free bonds will become available in 2017 which might yield good returns. These could include bonds from the Indian Railways and other Government authorities like the Rural Electrification Corporation (REC). You could also pick up several corporate bonds and Non-Convertible Debentures (NCD) from the secondary market. NCDs such as ones issued by top banks are good options with high return and low risk. It is important to invest only in highly rated bonds, available at an attractive Yield to Maturity (YTM). YTM is the yield that you would get by holding the bond.

You could also pick up several corporate bonds and Non-Convertible Debentures (NCD) from the secondary market. NCDs such as ones issued by top banks are good options with high return and low risk. It is important to invest only in highly rated bonds, available at an attractive Yield to Maturity (YTM) (YTM is the yield that you would get by holding the bond till maturity). You needn’t calculate the YTM. Websites like www.edelweiss.in, provide you with all details of listed NCDs and bonds. This includes YTM, coupon rate, last traded price and other details.

Bank Fixed Deposits are also a good option right now. However, note that experts predict that FD rates might fall by 50-100 bps in 2017. So, the current rates of 7%-7.5% are pretty good especially if one considers long-term FDs. If you want to save some tax, you could consider tax saving FDs offered by the top banks, which offer higher returns.

While corporate deposits are an option, they should be avoided in the current scenario. This is because growth in India is still stagnant. GDP growth for the country is high when compared to other nations, but has not shown great improvements in the past year. The demonetisation drive is expected to hit our GDP further. When this happens, industry growth, output, and revenues will also be likely to take a hit. This could result in defaults in some sectors and downgrades in others. That is the reason why you should be wary when choosing corporate Fixed Deposits.

Go long – The interest rate cycle will be on a downward trend for quite some time. The next year will be no different from 2016. This means that you might see these high interest rates for a few years to come. Given the scenario, it is best to invest in long-term options so that you continue to get high returns for a long duration. By long-term options, we mean instruments that have a duration of more than 3 years.

What are the risks you will face? Given the Indian scenario, there are several risks that you might encounter in the coming months.

Reinvestment risk – Since interest rates are falling, if any of your investments mature in 2017, you would have to reinvest them in instruments yielding lower returns. In order to avoid this risk, refrain from investing in short-term securities that would mature in 1-3 years, unless you really need the money. Also, create a fixed income investments ladder. This strategy requires you to invest an equal amount of money in instruments that mature on different dates. This way only a portion of your investment would be subject to reinvestment risk and lower returns. Also, this would ensure that your portfolio’s liquidity is higher. You could use FDs, bonds and Government securities for creating ladders.

Credit risk – This is perhaps the biggest risk that fixed income investors could face in 2017. When interest rates are falling and credit demand is sluggish, tackling credit risk is crucial. It is important for you, as a fixed income investor, to avoid it or at least minimise it. This is applicable to all those who invest in corporate bonds, debentures and deposits. Here’s why these instruments are not worth investing in:

The credit risk, or risk of default of several corporates, is likely to go up next year. This is mainly due to the growth slowdown in the country. The main factors that have slowed the growth of India Inc. include the delay in passing on of interest rates to corporates. This has translated into higher debt payments for companies. If they don’t earn enough to repay their debt, they might default on interest payments. So, you, as a lender to the company, are at great risk. Corporate instruments are, therefore, best avoided.

But, if you want to invest in corporate bonds and deposits despite the risk, keep track of the company’s credit ratings so that you can make a timely exit in case of downgrades. India’s Gross Domestic Product (GDP) figures, manufacturing growth, credit growth, and RBI policy moves are key factors that could trigger credit rating changes. The budget for FY17-18 and the reaction of credit rating agencies to it will also be crucial.

What must you not do? Investing in the right instruments makes you a smart investor, but avoiding the wrong investments makes you smarter. Here are the investments that you should avoid in the coming months.

Don’t float – Floating rate bonds are bonds whose interest rates are benchmarked to the interest rates prevailing in the market. Once interest rates start to fall, interest rates on the floating rate bonds will also fall. So, avoid investing in these bonds

Don’t take the call – In the coming days, there may be several bonds which offer high interests with a call option. A call option is when the issuer reserves the option to call back the bond after the passing of certain time frame. Generally, these bonds are issued at high interest rates. After interest rates fall, the issuing company is often unable to pay these high interest rates resulting in them calling back the bond. This forces the investor to reinvest the proceeds from the bond in low-interest yielding instruments. Therefore, avoid investing in bonds which have call options.

The loved/dreaded word – BTT

It is highly unlikely that the Banking Transaction Tax (BTT) will get implemented in 2017. However, if BTT replaces the present taxation system, it will not be happy news for everyone.

Now, what is BTT?  BTT is a tax on all banking transactions, irrespective of whether they are through Credit Cards or Debit Cards. It is said that a 2% tax will apply on all banking transactions. This applies to cheque payments and electronic transfers also. This means that those that were never under the taxation bracket, will now be subject to taxes. However, for all others in the higher tax bracket, this is great news. Imagine someone in the 20% tax bracket, paying just 2% in taxes? Now, that will be a delight! The bad news is that the lower income category will be subject to the same taxation as the rich, which sounds ridiculous. Obviously, there will be a lot of opposition to this form of taxation. If the BTT ever gets implemented, the way you should invest will surely change.

In conclusion, it isn’t going to be that bad for fixed income investors if they keep their eyes and ears wide open and make the right moves to come out on top.

Here, we try to give you the gist of the article if you just browsed through it or want to keep some points in mind.

Big Picture

Inflation to settle after drop – Inflation is likely to go down to about 4% by the first quarter of next year but is unlikely to go down any further.

Interest rates to fall – Interest rates are expected to fall along with the drop in inflation. The general expectation is a fall of 25-30 bps.

Bond yields to drop – As interest rates in the country fall, bond yields will also drop. But, it is expected that the drop won’t be that drastic since they have already fallen quite a bit.

FD rates might go down – Along with interest rates in the country, FD rates might also fall by 50-100 basis points next year.

Action Plan

Lock in rates – This is the time to invest in high yielding fixed income options and lock in the rates. The best investments would be Government securities, Bank FDs, tax-free bonds, and corporate NCDs.

Invest for the long term – Since interest rates are going to remain on a downward trajectory, it is best to invest in high return instruments for a longer duration. This way, you will get high returns for a long period of time.

Ladder investments – In order to minimise reinvestment risks and ensure liquidity, you could ladder your investments. This would ensure that all your investments are not reinvested at higher returns, and you get money in intervals to meet your financial needs.

Be a better investor

Avoid floating rate instruments – The interest rates of floating rate instruments could fall with a drop in interest rates. So, you might get lower returns from these instruments in 2017 too.

Avoid bonds with call options – Bonds with call options give the issuer the right to call back the bond after a set time frame. Usually, issuers call back bonds when interest rates go down. This would result in a reinvestment risk for you.

Avoid corporate deposits – With India’s growth looking to drop, India Inc. is battling with several problems including a slow fall in loan rates. So, credit rating downgrades of companies as well as defaults on interest payment by corporates are possibilities in 2017.

You can make those gains from your investments by just being aware of what’s happening around you. If you need to know that latest on the finance front, we are always around.

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