Be prudent in fixed income investments

As stock markets world-over witnessed declines, Indian investors while focusing on their equity portfolio should also take a re-look at their fixed income investments and restructure it according to the changes.

The income tax rate slabs for the current financial year have been revised thoroughly for individuals. The marginal rate of 30% of income is applicable only for individuals with income above Rs 5 lakh, while the basic exemption limit has been raised substantially upwards for male, female and senior citizen assesses.

If this year’s income was the same as the last financial year, then the tax payable will be substantially lower—mainly because the rate of tax at lower levels of income has been reduced drastically.
Secondly, the interest rates on options like bank fixed deposits , fixed maturity plans (FMPs) of mutual funds, corporate fixed deposits among others have gone up by more than 2-3 % per annum.

But the interest rate on schemes like PPF, National Savings Certificates , Kisan Vikas Patra, Post Office Monthly Income Scheme as well as taxable government bonds and Senior Citizen Savings Scheme, has remained static at 8-9 %.

Thirdly, inflation, which has risen lately, has started showing signs of tapering off. It may come down over the next few months, which will mean that the interest rates too will start falling. If interest rates fall, it makes sense to commit to fixed income schemes offering higher rates of interest for a longer term.

Premature exit options and withdrawals before maturity are not available in National Savings Schemes and 8% taxable government of India (GOI) bonds. In respect of all other fixed income options, an investor can withdraw or close prematurely the lower yielding investments and invest at current high rates.

We should find out whether it would be beneficial to withdraw from these options and invest in higher yielding options available. The important factor that would influence this decision is the rate of taxation on one’s income. We will bifurcate the investors as those who are required to pay tax at the rate of 10% or lower and others at the rate of 20% or more.

Withdraw the maximum amount from your PPF account and invest in bank FDs and FMPs of longer maturities of two years or more. If you can close the account and withdraw the entire amount, then it’s recommended.

Before maturity, withdraw your investments from the Senior Citizen Savings Scheme, even if you need to pay a penalty of 1%, and invest the amount in bank FDs offering 10% or more. Tax deduction at source (TDS) on a Senior Citizen Scheme, besides the interest rate of just 9% per annum, is a big irritant for senior people.

Hence, avoid this hassle and invest in different branches of banks. If you ensure that the interest on your FDs with a bank does not exceed Rs 10,000 in a financial year per branch, then TDS on interest can be avoided.

Consider premature renewal of your old bank FDs earning a lower rate of interest . Banks consider this without any penalty and roll over your FDs with them at the current interest rate. Long-term deposits of say three years or more are preferable.

FMPs are the best option for this category of investors. With draw your money from FDs postal schemes among others before maturity and invest in FMPs. The expected yields are even higher than the interest rates on FDs. The tax adjusted yields on FMPs of more than one year is much higher compared to FDs.

The difference between the amount received and the amount invested is considered as long-term capital gains and it is taxed at a rate of 10% without indexation of cost of acquisition or 20% with indexation benefit—under the growth option. As inflation is ruling high, the application of double indexation benefit to a 19-month FMP which will mature after March 31, 2010, will mean a taxfree income at the rate of more than 10% per annum.

Investors who will pay tax at 20% or more
Long-term FMPs should be preferred to short-term ones as the interest rates are likely to go down after a few months. The growth option would be a better one compared to the dividend pay-out option as the fund will be required to pay a Dividend Distribution Tax which is currently 12.5% plus a surcharge and education cess among others (effectively 14.1625%).

For investors parking funds in monthly and quarterly interval FMPs, the dividend pay out option will be better. FMPs do not guarantee a fixed rate of return and there is a risk of getting lower yields compared to indicated yields.

RBI cuts CRR by 100 basis points

The Reserve Bank of India on 15/10/2008 Wednesday cut the Cash Reserve Ratio (CRR) further by 100 basis points to 6.5 per cent of NDTL with effect from the current reporting fortnight that began on October 11, 2008. This measure will release additional liquidity into the system of the order of Rs.40,000 crore.

On Tuesday, October 14, 2008, the RBI decided to conduct a special 14 day Repo at 9 per cent per annum for a notified amount of Rs 20,000 crore with a view to enabling banks to meet the liquidity requirements of mutual funds. Rs 3,500 crore of this facility was utilised by banks yesterday.

Further, the Reserve Bank announced this morning that this 14 day repo facility will now be conducted every day until further notice upto a cumulative amount of Rs 20,000 crore for the same purpose. Banks obtain liquidity from the Reserve Bank under the Liquidity Adjustment Facility (LAF) against the collateral of eligible securities that are in excess of their prescribed Statutory Liquidity Ratio (SLR).

It has been decided, purely as a temporary measure, that banks may avail of additional liquidity support exclusively for the purpose of meeting the liquidity requirements of mutual funds to the extent of up to 0.5 per cent of their NDTL. This additional liquidity support will terminate 14 days from the closure of this special term repo facility announced on October 14, 2008. This accommodation will be in addition to the temporary measure announced on September 16, 2008 permitting banks to avail of additional liquidity support to the extent of up to 1 per cent of their NDTL.

Interest Rates on FCNR (B) Deposits

Currently, the interest rate ceiling on FCNR(B) deposits of all maturities has been fixed at Libor/Euribor/Swap rates for the corresponding maturities minus 25 basis points for the respective foreign currencies. In view of the prevailing market conditions, RBI has decided to increase, with immediate effect, the interest rate ceiling on FCNR (B) deposits by 50 basis points, i.e., to Libor/Euribor/Swap rates plus 25 basis points.

Interest Rate on NR(E) RA Deposits

Currently, the interest rate ceiling on NR(E) RA for one to three years maturity should not exceed the Libor/Euribor/Swap rates plus 50 basis points for US dollar of corresponding maturity. In view of the prevailing market conditions, RBI has decided to increase, with immediate effect, the interest rate ceiling on NR(E)RA deposits by 50 basis points, i.e., to Libor/Euribor/Swap rates plus 100 basis points.

Banks will be allowed to borrow funds from their overseas branches and correspondent banks up to a limit of 50 per cent of their unimpaired Tier I capital as at the close of the previous quarter or $10 million, whichever is higher, as against the existing limit of 25 per cent.

The above measures will be reviewed on a continuous basis in the light of the evolving liquidity conditions.

The Reserve Bank is monitoring developments in the financial markets closely and continuously and would respond swiftly and even pre-emptively to any adverse external developments impinging on domestic financial stability, price stability and inflation expectations. The Reserve Bank is committed to maintaining financial stability and active, and flexible liquidity management using all policy instruments is an integral part of this objective.