The Reserve Bank of India (RBI) has cut the repo rate by 25 basis points (100 basis points is equal to one per cent) to a six-year low of 6.25 per cent.
This can be good news for borrowers as banks are expected to reduce the lending rates. But this could also mean that your fixed deposit rates might go down further.
Ashutosh Khajaria, Executive Director, The Federal Bank Ltd, says, “To bring down their marginal cost of lending rate (MCLR), banks have to first cut their cost of deposit. It won’t be possible for banks to bring material changes in lending rates without cutting the cost of deposit.”
MCLR is linked to incremental deposit rates, which means banks fix their lending rates on the basis of their current cost of funds. Earlier, the benchmark lending rate was the base rate, which depended on the average cost of funds.
So, if banks start reducing their deposits rates, it will impact those who use bank FDs to park their savings to draw regular, assured income. Bank FDs are the most favoured investment among Indians, especially retirees, despite the fact that they deliver poor inflation-adjusted returns and are highly tax inefficient.
The interest on bank fixed deposits is fully taxable and is added to the income of the depositor to be taxed as per tax slab.
Currently, banks are offering an interest rate of around 7-7.5 per cent on deposits with tenure of 1 to 10 years but with inflation hovering around 5-6 per cent, the real returns from fixed deposits will be almost negligible.
As the interest rates have been on a downward trajectory, experts have been advising investors to look for alternatives to fixed deposits.
Debt mutual funds can be one of the tax-efficient alternatives for those who are willing to take some amount of risk, say experts.
In a falling interest rate scenario, while the interest rate on fixed deposits go down, debt funds actually tend to benefit from it, especially those investing in longer duration papers. Over the past one year, debt funds that invest in longer maturity papers have delivered double-digit returns.
Debt funds also have a tax advantage over fixed deposits. The capital gain from debt funds after three years is taxed at the rate of 20 per cent after indexation.
This means that the capital gain is adjusted to the price rise, which reduces the tax impact to negligible levels. In the short term (less than three years), the gains from debt funds are taxed like fixed deposits that is added to the income of the investor and taxed as per slab.
Experts feel that debt funds are still expected to deliver good returns in the near future.
Among debt funds, dynamic bonds, which invest in a variety of debt papers with varying maturities, can be a good option, say experts. In case of dynamic bond funds, the fund manager has the liberty to change the maturity of the fund as per the interest rate scenario.
“Because of rate cut, some rally is still left in the dynamic bond funds, they will get optimal return to investors with a three-year time frame,” says Vidya Bala, Head of mutual fund research at FundsIndia.
For investment horizon of up to two years, Bala advises investors to invest in short-term mutual funds, which invest in debt papers with maturity of up to 2-3 years.