Falling interest rates: Here are four ways to manage reinvestment risk

By: | Published: August 9, 2017 2:58 AM

Given the falling interest rate regime, investors should go for long-term small saving schemes such as NSC, Kisan Vikas Patra or 5-year post office fixed deposits and monthly income schemes, tax-free bonds from the secondary market besides liquid and ultra short-term debt funds.

interest rates, reinvestment In order to reduce the reinvestment risk, fixed-income investors should ideally buy long-term debt instruments and lock into the current interest rates.

As banks are reducing interest rates on fixed deposits and even savings accounts, those whose deposits are maturing face reinvestment risk. Their earnings from investments will fall in the future because of the falling interest rate regime. On August 2, the Reserve Bank of India (RBI) reduced the repo rate by 25 basis points which should spur banks to cut rates further. Falling interest rates will prevent investors of fixed coupon payments from earning the same rate of returns after maturity. For instance, the 5-10 year State Bank of India fixed deposit rate for deposits below Rs 1 crore is now 6.25%, down from 9.25% in February 2012. In such a situation, it is becoming difficult for risk-averse, fixed-income retail investors to earn higher returns.

Lock into long-term debt products

In order to reduce the reinvestment risk, fixed-income investors should ideally buy long-term debt instruments and lock into the current interest rates. They can look at small savings schemes like 5-year National Savings Certificates which currently carries a 7.8% interest rate; post office 5-year Monthly Income scheme (7.5%); 9.4-year Kisan Vikas Patra (7.5%) or simply a 5-year post office fixed deposit to earn 7.6%. The next reset of small savings rate will take place in September-end, which will be applicable for three months of October to December.

In June this year, the government had cut small savings rates by 10 basis points for the second successive quarter. Since recalibrating the interest rates every quarter from March last year—based on the quarterly average of government securities (G-secs) of comparable maturity—the government has made four cuts in small savings rates.

Bond with the best

Long-term investors should look at tax-free bonds from the secondary market. These bonds were issued by state-owned firms like IRFC, PFC, NHAI, HUDCO, REC, NTPC, NHPC in the past with tenure of 10-20 years. Not having to pay tax on the interest earned on such bonds makes them more attractive than other taxable debt instruments. While the interest payments on these bonds are tax free, there would be capital gains tax if an investor sells before maturity at a profit.

Switch to debt funds

After State Bank of India cut interest rate of savings accounts to 3.5% from 4% after six years, other state-owned banks are reducing their rates and private ones may also do so. In such a scenario, individuals should look at various options in debt mutual funds to invest money for the short term and gain higher returns. The underlying assets of liquid and ultra short-term debt funds are government paper, commercial paper and treasury bills. Liquid funds are ideal to park surplus cash for short periods ranging from a day to 90 days.
Those who have surplus funds for six to nine months and are willing to take marginal risk to earn higher returns can invest in ultra short-term funds. Tax-wise, all debt based mutual funds are considered long-term when held for more than three years and short-term when held for three years or less. Short-term gains are taxed at the individual’s slab rates and long-term gains are taxed at 20% with indexation.

Gain with equities

In a falling interest rate regime, fixed-income investors should invest in equity through the systematic investment plan (SIP) of mutual funds. In fact, with the markets benchmarks, BSE’s Sensex and NSE’s Nifty, touching new highs, retail investors are increasingly investing in SIPs. In FY17, asset management companies added 6.26 lakh SIP accounts each month and the average SIP amount was Rs 3,100 per account.

SIPs allow an investor to buy units on a given date each month. One can start with a minimum amount of `500. The biggest advantage of an SIP is that the investor doesn’t have to time the market. Investing every month ensures that one is invested during the highs and the lows. One must start investing at an early age as longer the investment horizon, higher would be the returns.

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Switch to Hindi Edition