Investment options in a falling interest rate scenario

Feb 05 2013, 03:21 IST
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SummaryThe current interest rate scenario offers an option to lock in money at higher interest rates for the long haul. Since interest rates are falling, options like fixed deposits or high-yielding debentures can be considered for long-term investments.

The current interest rate scenario offers an option to lock in money at higher interest rates for the long haul. Since interest rates are falling, options like fixed deposits or high-yielding debentures can be considered for long-term investments.

However, softening of the interest rate by the RBI leads to a fall in the prevailing fixed deposit (FD) rates, i.e., banks may also reduce the interest rates on FDs.

Though fixed deposits are considered safe investment options, one needs to look at the marginal rate of tax since investments in fixed deposits are suitable for people in the lower tax bracket. Post-tax returns on FDs are not very attractive for those in the higher tax bracket.

Debt mutual funds & interest rate

Right now, we are in a falling interest rate scenario. The RBI started reducing interest rates from April 2012. Interest rates are cyclical and they canít remain stagnant for a long time, especially in an economy like India, which is growing at a fast rate. Falling interest rates provide investors not only an opportunity to lock in money at high yields, but also offers capital gains from the rally in bond prices.

How it works?

The prevailing interest rates in the economy have a direct impact on financial markets. In various phases of the interest rate cycle, different categories of mutual funds outperform the market. In a falling interest rate scenario, debt-oriented funds, mostly with a higher average maturity, do well. This is because debt funds invest in fixed-income securities issued by the government, banks and corporate bodies and these securities have a specified coupon rate.

When the interest rate falls, the value of outstanding bonds rises because the income (coupon) they pay is more than what investors could receive on new bonds. Thus, the yield on bond increases and, so, the net asset value (NAV) of debt fund increases.

Debt MF options

Gilt funds get impacted due to the interest rate cycle. Gilt funds invest in government securities that have average maturity between 1,000 and 3,000 days. Funds with high average maturity have higher sensitivity to interest rate changes. Income funds also get some heat due to any change in the interest rate scenario as they invest in fixed-income instruments issued by the government, banks and corporate bodies. Income funds maintain an average maturity of 700 to 2,300 days.

Liquid & ultra-short-term funds are the categories that are mostly used for parking surplus

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