Make high interest rates work for you

Interest rates are set to climb further. This presents an opportunity for investors to seek better returns by choosing carefully from a menu of debt investments that combine good returns with safety.

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Aarati Krishnan

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Rising inflation and spiralling interest rates have infused a big dose of uncertainty into the outlook for stocks and made them lurch wildly between one trading session and another. But these very factors present a window of opportunity for debt investors, who can now look forward to lucrative investment returns. Interest rates which, by end-2007, were expected to peak and embark on a gentle downward slide, have unexpectedly climbed further in the past six months.

The central bank's attempts to cool runaway inflation through hikes in policy rates and mop up excess liquidity has pushed up the yields on debt instruments across tenures. The repo rate (the rate at which banks borrow from the RBI) is up from 7.75 to 8.5 per cent over this period, while the CRR (cash reserve ratio, the proportion of funds that banks have to statutorily park with RBI) will be at 8.75 per cent (up from 7.5 per cent in December), once recent increases take effect.

Interest rates on government securities and corporate bonds have already risen in response. In barely six months from January to July, yields on one-year government bonds have climbed from 7.45 per cent to 9.25 per cent and those on 10-year gilts from 7.8 per cent to 9.4 per cent.

Blue-chip corporate bonds (AAA rated) now offer 10.6 per cent, 1.5 per cent more than levels barely six months ago. These trends are also being reflected in fixed debt options such as bank and company deposits. So, how can investors capitalise on rising interest rates? From a menu of debt investments that offer market-related interest rates, what should they now favour? How should they deal with their big-ticket borrowings?

Scope to head higher

Before proceeding to answer these questions, a key call that investors will have to make is where interest rates will head from here. Will they keep rising, offering even better opportunities for debt investors in the months ahead? Or will they tumble, requiring you to grab the good debt deals while they last?

Fortunately, that's an easy call. Today, bankers and economic forecasters are surprisingly united in their verdict that India's interest rates will continue their climb at least till the end of 2008.

Inflation, at over 11 per cent, is well out of the RBI's comfort zone and forecasts suggest that the number is likely to remain near the double-digit mark over 2008 and stay out of the comfort zone, well into 2009.

Bankers believe that as long as inflation remains well above the target zone, policy measures to curb liquidity will continue. This may mean that interest rates will likely increase through 2008 and may not taper down in a hurry even in 2009.

Over the next few months, predictions are for a further 0.25 to 0.50 per cent increase in the repo rate and a 0.50-1 per cent increase in the cash reserve ratio (CRR) from the current levels. This is bound to reflect in debt returns across a range of instruments. Having decided that interest rates would continue their climb, what are the options for your portfolio?

How they stack up

Bank term deposits: Interest rates on term deposits, which were beginning to soften in end 2007, are now upward bound. Several banks have revised interest rates on their term deposits effective July 1, with the sharpest revisions happening in the 1-2-year windows.

Tightening liquidity is also prompting banks to open up their "special deposit" schemes once again. SBI now offers 8 per cent on deposits from 181-364 days and 9.5 per cent on 1-3 years. ICICI Bank offers 8.5 per cent on terms ranging from 1 year to 389 days and also offers a 390-day deposit with a 9.25 per cent interest rate.

Recommendation: Attractive rates and high marks on 'safety' make this an opportune time for the more passive investors to sweep their savings bank surpluses into bank term deposits. The best deals in bank term deposits are now available in the 1-2 year window; locking in for a longer tenure does not necessarily yield better returns.

With more hikes in the CRR expected, term deposit rates are likely to tread further upwards in the coming months. Investors who are willing to actively track interest rates can park surpluses in short term options (read: liquid MFs) and switch into term deposits after another round of revisions in interest rates. Waiting awhile may allow you to lock into higher rates for the long term.

Fixed maturity plans: If bank term deposits score high on the safety factor, FMPs rolled out by mutual fund houses offer much better post-tax returns. FMPs, usually open for short periods of 3-4 days, are available in terms ranging from 3 months to slightly over one year and allow you to lock into prevailing interest rates for corporate bonds and gilts when you buy the fund.

As indicative yields (now at 10-11 per cent for one-year plus FMPs) are provided at the outset, returns are fairly predictable. Shopping for FMPs which offer good rates for the shortest possible term makes sense, as this will allow you flexibility to capitalise on further rate increases. While term deposits suffer taxation at your marginal tax rate, returns on FMPs are subject to capital gains tax.

Recommendation: One year-plus FMPs may help investors in the 30 per cent tax bracket earn a higher effective return compared to term deposits offering similar rates. But do note that an FMP carries a higher risk profile than a bank deposit. Chasing an FMP purely on the basis of an exceptionally high "indicative" yield is not advised as this may require the manager to assume higher levels of risk, while shopping for better yields.

Company fixed deposits: Interest rates on deposits taken by companies too are trending up, with NBFCs leading the pack in offering attractive rates. Interest rates on one-and two-year deposits from manufacturing companies now fall in the 8.5-11.5 per cent range. After revisions effective July 1, Sundaram Finance offers 10 per cent on its one-year FD and 10.50 per cent on two and three year FDs. This remains an attractive option for conservative investors with low tax incidence.

Recommendation: Investors should opt for company FDs only if they offer a sufficient "risk premium" over bank term deposits, given recent revisions in the latter. Analysis of company financials is a must before you invest. With margin pressures and a tough macro environment set to take a toll on company earnings over the next couple of years, companies in capital-intensive businesses may face liquidity constraints. Bank deposits may score on safety and flexibility (more in-between tenures) and FMPs on tax efficiency.

Short-term debt funds: If you would like the returns on your debt investments to "float" up with rising interest rates, short-term debt mutual funds (maturity periods of less than a year), which offer market-related returns, appear to be the best option.

The high liquidity on such products (you can exit at NAV-based prices any time) is a big plus, as it allows plenty of leeway to switch to higher yielding options at the exact time of your choice.

Medium and long term debt funds (check out the average maturity period of the portfolio) are best avoided, as they may deliver flat or negative NAV returns (due to falling bond prices) in a scenario of rising interest rates.

Floating rate funds, despite their name, suffer from disadvantages relating to the availability and valuation of instruments. Therefore, sticking with Liquid and Liquid Plus funds and Short-term bond funds appears to be the best option.

Recommendation: Returns for short-term bond funds have been in the 8 per cent range for one year, while liquid funds have delivered 8.3 per cent.

There is also potential for returns to move up from current levels, as market yields on short term instruments trend up on tight liquidity. But as there is significant divergence between funds, look for established debt managers with a good 3-year record. These debt funds are a good parking ground for your surpluses if you would like to wait before you lock into a term deposit or are looking to re-enter stocks at a later date.

Restructuring borrowings

Investments apart, rising interest rates may also require you to re-evaluate your decisions to borrow. Home loan interest rates generally tend to be quite sticky and have not risen in tandem with market interest rates over the past year.

Recent increases, made after a year's gap, have taken floating rate home loan interest rates to 11 per cent for leading providers such as ICICI Bank and HDFC. A further 0.25 to 0.50 percentage point increase cannot be ruled out, to compensate for further increases in market rates.

If you are a borrower, two key decisions that arise from this are: whether you should switch/opt for a fixed-rate home loan and whether you should prepay an existing loan. On the first, the answer appears to be a "no" at this juncture.

Though fixed rate loans have the advantage of predictable EMIs, they appear too expensive at this juncture — at interest rates of 13-14.75 per cent p.a.(without a reset clause), considering that floating rates are only expected to move up by 0.25-0.50 percentage points. Both the competitive scenario as well as the fear of defaults is likely to make banks tread cautiously on pegging up floating rates on home loans at frequent intervals.

A decision to pre-pay the loan will depend on how much surplus cash you possess and the rates at which you are hopeful of reinvesting this. If you are in the 30 per cent bracket, tax savings on the interest outgo will tend to trim the effective interest rate on a 11 per cent floating rate home loan to 7.7 per cent.

You can consider prepayment, only if your investments fail to beat this "hurdle" rate of return over the long term. Prepayment penalty, usually levied at 2 per cent of the outstanding loan, will also add to the cost of prepayment.