Rate cut? Small savings schemes can still fetch you high returns

Even if interest rates go down, small savings may continue to offer better returns than fixed deposits, explains Adhil Shetty.

The government is soon likely to rationalise interest rates on small savings schemes.

This will help banks to transmit the policy rate reduction by the Reserve Bank of India (RBI) to borrowers.

Banks have not been able to do so because their fixed deposits (FDs) will become uncompetitive compared to the small savings schemes if they reduce the rates.

Fixed deposit rates are already on the decline in recent times. A fixed deposit account last year on an average offered annual returns of 8-8.5 per cent and over nine per cent for senior citizens.

Today, these schemes pay no more than 7-7.5 per cent interest on average.

Compare this to the post office recurring deposit and the post office time deposit scheme, that offers a rate of interest of 8.4 per cent, and the choice today would be clear for investors.

Even the PPF scheme offers interest of 8.7 per cent with tax-free interest unlike fixed deposits.

Unless the interest rates of small saving schemes are pared, investors are likely to stay away from bank fixed deposits during a repo rate reduction regime.

If the Finance Ministry links the interest rates of small savings to a benchmark and align it with the market rates; it will allow banks to reduce deposit rates and thereby the lending rates without impacting their interest margins much.

For retail investors, this mean lower rates on schemes such as public provident fund (PPF), Post Office fixed deposit scheme, senior citizen's savings scheme (SCSS), Post Office monthly income scheme (MIS) and Sukanya Samriddhi Accounts.

According to reports, the finance ministry may consider fixing the small savings rate at par with the five-year government security yields.

The alignment could be done on a quarterly basis to ensure that small savings rate does not become an impediment in the monetary transmission process.

Another option that the government may consider is differential interest rates on small savings according to age groups, similar to the benefits provided to senior citizens by banks.

Banks normally pay 25-50 basis points higher interest on senior citizens' deposits.

Investors today enjoy 8.7 per cent tax-free returns for their investment in PPF.

This means if this rate persists, someone who has invested Rs 1 lakh for five years would get Rs 1.54 lakh in return. 

As an indicative estimate, if the PPF rates are brought down to 8 per cent, a person investing after the proposed rate revision would get only Rs 1.49 lakh after five years - a loss of Rs 5,000.

However, this may not be a significant loss, considering PPF is only a small part of your investment portfolio.

PPF as an investment tool offers tax benefits, and the returns are tax-free.

Should you be worried?

If you have been investing in small saving instruments, there is not much cause for concern about the possible interest rate cut, as the impact or loss on your portfolio would be minimal.

Even if the rate cuts on small savings turn out to be substantial, there are other investment options that you can consider, allowing you to get better returns than small saving instruments.

Let's look at how the situation will change if small savings rates were to indeed come down.

Fixed deposit vs tax-free bonds: Suppose you invest Rs 1 lakh in a bank fixed deposit with a maturity period of five years at an interest rate of 7.5 per cent. At maturity, you will get a total amount of Rs 1.45 lakh. However, the money earned will be taxed as per your income tax bracket. Even if taxed at the lowest tax slab of 10 per cent, the post-tax returns would be Rs 1.3 lakh. 

On the other hand, if you opt to invest in a tax-free bond with seven per cent coupon, it will give you a total tax free interest of Rs 41,478, yielding a sum of Rs 1.41 lakh at the end of the five-year tenure. Thus, you stand to gain Rs 11,000 by choosing tax-free bonds over tax inefficient fixed deposits.

Government bonds: If the government links interest rates of small saving instruments with the market rates, investing in government bonds can be a good option since they come with a security of assured returns like bank FDs but are tax free.

Debt Funds: If you are slightly risk-averse, you can choose to invest in debt mutual funds along with small saving instruments. As an investor, you can choose long term funds as they usually invest in government bonds and corporate papers. Any drop in interest rates augurs well for investment in such funds. Though the returns are not tax free, they work out to be much lower than bank FDs if a person remains invested for over three years.

Stocks: Equity markets may offer you better returns than small saving schemes, but it requires good understanding and sometimes, a lot of patience. Unless you understand the world of investing, the best option is to explore mutual fund investments. Even then, do not ignore the tax component and the likely risks. Unless you are open to market risks, do not consider equity markets as a possible alternative.

To ensure a balanced portfolio, avoid any knee jerk reaction as and when the interest rates on small saving instruments are reduced.

Irrespective of lower interest rates, all financial components like bank fixed deposits, PPF schemes, NSC, SCSS and Sukanya Samriddhi Accounts all have their place in an ideal investment portfolio, due to the security, tax benefits and returns they offer.

Apart from the immediate rate fluctuations, in the long run, the overall interest impact can be different.

Also, check the effective post-tax returns when you choose investment avenues.

Since small saving schemes like PPF offer tax free returns and risk-free, they would still be a good bet for the long term and can form a part of your portfolio.

The writer is CEO, BankBazaar.