Rate Cuts- What Should Be Your Debt Strategy?

If you are the type of investor who parks surplus money into fixed deposits (FDs) and small saving schemes (public provident fund, national savings certificate and senior citizen saving schemes), you might be worried because of the declining interest rates. This year alone, the Reserve Bank of India has cut the repo rate by 1.25% so far and it currently stands at 6.75%.

These cuts have, in turn, led banks to reduce their interest rates on FDs. Noteworthy of these is the State Bank of India which has recently cut interest rates on 1-year fixed deposit by 25 basis points and overall has dropped the rates by 1.50% in this year to 7.25% p.a.

The interest rates on small saving schemes are also expected to drop as the yield on government securities to which the interest rates on SSS are aligned has been declining (8.01% in January to 7.5% in October, down by 4%) over the past one year.

So, is there any debt option that will benefit from rate cuts and is more tax-efficient than fixed deposits? Yes, debt funds offered by fund houses benefit during the falling interest rate regime. By investing in these funds you get indexation benefit on gains from the investments made for more than 3 years, resulting in lower tax outgo.

First, let’s understand how interest rate movements impact debt funds’ returns.

The inverse relationship

Debt funds invest in debt instruments of government and corporate sector of varying maturities to earn returns from the interest income and capital appreciation. When there is a fall in interest rates, the prices of debt securities issued earlier go up due to higher demand as they carry higher interest rates. The longer the tenure of the securities, sharper will be the rise in price as the securities promise to give higher coupon for a longer tenure.

Therefore, debt funds with longer maturity benefit more from rate cut. That is Income funds (investing in medium- to long-term debt papers) have delivered a return of about 12% while gilt medium- and long-term bond funds (invest only in government securities) have delivered a return of about 15% over the past 1 year.

Table 1: Debt funds’ performance

The question one can ask here is as the debt funds have witnessed a huge rally would there more to come? Will they continue to deliver such returns?

The answer is — it depends on the interest rate movement which in turn will depend on factors such as inflation. There are other domestic factors such as monsoon, economic data and global factors, such as Federal Reserve move on rate cuts and global commodity prices especially oil, that will decide the future course of action on interest rates by RBI.

But if rate cut happens, income funds especially with longer maturities are definitely going to benefit from it.

Table2: Top performing Income funds