think short term
Before you lock your money a Fixed depositKeep in mind that the repo rate may increase further. Although inflation has moderated, it is still above the RBI’s tolerance level. Many analysts believe that there is scope for further hike in the repo rate by 35-50 basis points. If this happens, the bond yield will also increase. So investors should go for short term deposits of 12-15 months instead of locking in for long term. More importantly, assess the fundamentals of the institution before investing. If investing in bank deposits, make sure the bank has solid backing. Some banks, especially co-operative banks, offer very high interest, but may not be able to repay your money. Similarly, check the credit rating of NBFCs before taking the plunge.
small savings and RBI Bonds
The rise in bond yields is also good news for investors in small savings schemes and RBI bonds. Rate of interest Small savings schemes are linked to the yield of government securities of the same duration. However, this rule has not always been followed for T. The benchmark 10-year bond yield rose 140 basis points to 7.46% in June 2022 from 6.04% in June 2021. But the interest rates of small savings schemes were not increased. Even if small savings rates are not increased, at least there will be no cuts. If small savings rates remain high, investors in RBI’s floating rate bonds will also benefit. The interest rate of these bonds is linked to NSC. They offer 35 bps more than NSC. The prevailing rate of NSC is 6.8%, hence RBI is offering floating rate bonds of 7.15%. If the NSC rate is increased to 7%, the interest rate on these bonds will be 7.35%, which is at par with 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 term schemes with very long duration bonds. Long term bond funds have given modest returns of 2-3 per cent, with bond yields rising by more than 100 basis points in the past one year. Even short term funds, which are not so badly affected by interest rate fluctuations, gave less than 4%. However, this does not mean that investors should stay away from debt funds for now. In fact, it is time to invest in these funds as there is limited bounce in bond yields. If inflation is controlled by a hike in interest rates and other policy measures, bond yields could start to decline.
If this happens then long duration and gilt funds can give good returns. While debt funds are subject to volatility as they are mark-to-market, they tend to score over fixed deposits over a longer period. While interest from fixed deposits is fully taxable at the normal rate, gains from mutual funds are taxed only at the time of redemption. Also, if held for more than three years, gains from debt funds are taxed at 20% after indexation benefits. Indexation takes into account inflation during the holding period, and accordingly adjusts the purchase price upwards to reduce tax. In times of high inflation, indexation can reduce the tax to zero.
best of both worlds
The prevailing elevated bond yields mean that investing in a target date fund can be very rewarding. They provide investors with everything they look for in a fixed income instrument. If you want certainty of returns, anytime withdrawal facility and benefit of low 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 fixed return on investment. A fund’s Yield to Maturity (YTM) is an indicative return that an investor would get at the end of the fund’s tenure. Right now, the YTM of many target debt funds is over 7%. Given the high inflation, after-tax returns from a target date fund with a YTM of 7.3% and held for more than three years could be as high as 7%.