Falling interest rates and investment options to beat them

The past couple of months have been tough for ultra conservative investors after seeing headlines mentioning falling interest rates. Ever since State Bank of India cut the interest rate on savings accounts to 3.5% on July 31, several banks have followed and many more are likely to do so in the coming days as well.

So, what should be your course of action?

Well, first and foremost, don’t panic. Falling interest rates does not mean all is lost. Take a look again at your financial short-term and long-term goals based on which you can consider some of these alternate investment options.

Short-term (up to 3 years)

Fixed Deposits

For a vast majority of Indians, an “FD” is often the go-to investment choice as an alternative to savings deposits. While the interest rates are higher, do keep in mind that the effective return will be much lower after factoring in the effect of inflation and tax on the interest. Secondly, it is quite possible that banks may lower rates for fixed deposits too. Nevertheless, it is still an option to consider if you’re completely risk averse.

Corporate Deposits

There are corporate deposits which offer higher returns compared to fixed deposits in banks. However, ensure you check the rating assigned to these deposit schemes as well as the company’s financial situation before you invest in them. Companies have been known to default and you could end up with a loss.

Debt Funds

Debt funds are a good alternative to savings deposits. A debt fund is one that invests in fixed income securities like bonds, commercial paper, money market instruments or floating rate debt.

For a 1–3 year investment horizon, you can look at short-term debt funds or even dynamic bond funds. Do remember that bond prices fall when interest rates rise.

If your investment horizon is between 3–6 months to a year, you can consider ultra-short term funds, and for a duration of 30–90 days, liquid funds would be most suitable. Liquid funds are fast gaining popularity because not only is investing painless, you can withdraw most of your money (subject to limits) in a matter of minutes now, which was not possible earlier.

Unlike bank/FD interest, which is taxed as interest income, debt fund income is taxed as capital gains. When held for more than three years, it is a long-term capital gain and taxed at 20% with indexation benefit, and when held for less than three years, it is a short-term gain and taxed as per your tax bracket.

Equity Linked Savings Schemes (ELSS Funds)

Investments in tax saving mutual funds can be beneficial if your horizon is around 3 years, since that is also the lock-in period. The amount invested in these funds is eligible for a tax deduction under Section 80C, and dividends (if you choose that option) are exempt from tax as well.

Long term (beyond 3 years)

Public Provident Fund

Although the Government has lowered the interest rate on PPF to 7.90% for Q12017, this is still an attractive risk-free option to invest your money for the long term. With a minimum tenure of 15 years, there is ample scope to build a decent corpus thanks to the power of compounding. As an added benefit, you get a tax deduction under Section 80C, and even better, the maturity value as well as accrued interest is exempt from tax.

Tax-free bonds

Tax-free bonds can be a good option for the long term (10–20 years), particularly if you’re in the highest tax bracket. These are offered by government companies like HUDCO, NHAI, NTPC, PFC, REC etc and while the amount you invest is not eligible for any tax benefits, the interest is tax free and investment is secured. However, if you sell them at a profit before maturity, it would attract capital gains tax. They’re often issued towards the close of the financial year and are listed on the exchanges as well, so investors can exit. However, be aware that liquidity depends on buyers being available.

Stock Market

Choose this option only if you have a healthy appetite for risk, and are comfortable with market highs and crashes. If you stay invested for the long term, you can get very good returns on your investment. Avoid the temptation to buy stocks on the basis of tips and TV shows — do your own research and then decide which stocks to invest in.

Equity mutual funds

If you wish to give your portfolio a boost but don’t have the time, inclination or expertise to invest directly in stocks, you can do so via equity mutual funds. Invest via Systematic Investment Plans (SIPs) for specific goals, like higher education / marriage of children and so on, using the double benefit of cost averaging and compounding to maximise your returns. If you wish to further reduce volatility, you can also consider ETFs and Index Funds — passively managed low cost options which mirror the performance of an index instead of trying to outperform it.

Bottom line — while these options will generate better returns than a savings account, not all are suited to everyone, so ensure you keep your risk appetite and financial goals in mind and invest accordingly. You should continue to keep 3–6 months worth of living expenses in your savings account which is quickly accessible to you at all times.

How are you beating falling interest rates? Do share your investment strategy in the comments :)

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Originally published at www.getwalnut.com on October 10, 2017.