Fixed income instruments’ interest rates lag behind inflation: Should you stay invested or exit?

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Updated: December 03, 2020 8:45 PM

Fixed income instruments, which usually give the rates of interest slightly higher than that of inflation, are giving significantly lower rates of interest.

fixed deposit, FD, fixed income instruments, rate of interest on fixed income instruments, rate of inflation, RBI policy rate, GDP growth, to exit or investDebt or Fixed Income is definitely an important portion of Asset Allocation.

The Reserve Bank of India (RBI) changes key policy rates depending on the condition of the economy and to provide an impetus to economic growth. One of the factors that influences the decision is inflation. When the inflation is high, the RBI keeps the policy rates high to encourage savings, so that spending reduces and similarly the demand pull inflation.

On the other hand, higher interest rates make borrowings costly for businesses, resulting in lower production and lower economic growth.

The slowing GDP growth amid high inflation has put the RBI in a Catch-22 situation. As a result, the central bank has kept the policy rates unchanged at a very low rate despite a high rate of inflation.

As a result, fixed income instruments, which usually give the rates of interest slightly higher than that of inflation, are giving significantly lower rates of interest, resulting in devaluation of money invested.

“Fixed income investors face this dilemma today as conventional fixed income avenues deliver negative real returns. The three-year AAA PSU return rate is approximately 4.5 per cent, which is a part of the yield curve where most of the money gets deployed. On the other hand, inflation due to supply side constraints is around 7.6 per cent. It leaves investors with a negative real yield of about 3 per cent,” said Nitin Rao, CEO, InCred Wealth.

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So, in a low rate of interest what are the options of investment?

Typically, there are two ways to increase returns on a fixed income portfolio – explains Rao.

a. Increase the duration: Yields are expected to stay benign for a prolonged period as RBIs priority is to get growth back on track in a constrained fiscal environment. This implies more headroom for rate cuts or prolonged period of rates being low. Hence, increasing the duration of a typical portfolio from 3 years to somewhere between 3 to 5 years will benefit investors with higher yield accrual and capital gains, if yields go down further. We recommend increasing duration into the longer end of the 3- to 5-year bracket.

b. Invest in lower rated instruments: While rates on high-rated instruments have come down due to liquidity chasing them, the other part of the fixed income market i.e. ‘credits’ has not been a beneficiary of this liquidity. It has resulted in yields and spreads on credits remaining high.

“This high yield and spread present an opportunity for fixed income investors as investors stand to benefit from higher accruals and yield compression as the economy gets back on track. We recommend investors to introduce 30 to 35 per cent credit in their fixed income portfolio through individual issuers or funds that have strong balance sheets, cash flows, and a diversified business,” said Rao.

When asked if Fixed Deposit (FD) is no longer a good investment option, Rao said, “The 3- to 5-year SBI fixed deposit yields are around 5.3 per cent. Post-taxation, which is assumed at 30 per cent, yield comes to around 3.7 per cent. In context of inflation highlighted above, a post-tax yield of 3.7 per cent would imply negative real returns. So, fixed deposit cannot be termed as an optimal investment in the current scenario. Investors must ideally bank on high-yield investments.”

So, what is the right move – to exit or invest?

“Investors should consider moving into more yield-enhancing avenues to maintain their purchasing power. Exiting is not a choice at all as it will further bring down the effective purchasing power of an investor. Debt or Fixed Income is definitely an important portion of Asset Allocation. Investors should consider distributing their investments across different rating profiles and different periods to optimize their returns,” said Rao.

“One can also consider investing in products of similar organisations in the secondary market e.g. investing in secondary market papers which give you a slight increase in returns over fixed deposits. For example if you invest in SBI Perpetual Bonds over SBI Fixed Deposits then the return will be about 2 per cent higher. A logical selection of similar or marginally lower investment papers in the same organisation will give you better returns,” he added.

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