Interest rates are coming down. What should one do?


sqrrl-bank interest rates

This has been a common question in various forums these days. As we all know, in the calendar year 2017, the interest rates have come down by a good number. Bank deposits offer lower rates as compared to last year. Even there are discussions regarding reduction in the interest paid on the savings bank account.

The lower rates are making depositors jittery. History suggests that whenever interest rates have come down below certain levels (nobody actually knows what such levels are, but it seems the current situation is one such), people start looking for alternatives – those alternatives that may offer higher yields.

Which are these alternatives and what are the pros and cons of the same?

If we glance through the history, there is a pattern across geographical markets – when the interest rates on safe products drop beyond a certain point, investors tend to chase yield, meaning they start looking for high yield instruments. In principle, there is nothing wrong in expecting high returns. The problem arises when one forgets the basic relation between risk and return. The relation is very simple – if you seek high return, you should be ready for higher risks; however, if you want safety, you should accept low returns.

With this background, let us understand the various products that many have opted for – often in order to earn higher returns.

  1. Company deposits: Companies are allowed to raise money in the form of equity shares or debentures through capital markets. They are also allowed to raise money through issue of public deposits. These deposits would be unsecured. If these deposits are issued by a company that is not an NBFC or a housing finance company, there would be no credit rating, too. This means, one is taking a bit high risk and one would have to assess the credit risk oneself.
  2. Unsecured deposits given to small businesses: This could be even more risky than the first one. In the above case, at least some of the companies may be well known with information available in public. In the case of small businesses, there would be no publicly available information. That makes it impossible to even evaluate some of the proposals. The risk goes up.
  3. Real estate: In case of real estate, there are two different types of investments:Investment in constructed property: Many have earned reasonably high returns from their real estate investments in the past. However, it is important to check if the calculated earnings were real. In most cases, the expenses and various taxes are missed out while calculating the investment returns. Investment in real estate is also subject to the risks of price fluctuations, lack of liquidity and non-divisibility. Price fluctuations are not transparently visible and hence we do not feel the presence of this risk. Lack of liquidity is understandable, but non-divisibility is another serious risk. You cannot sell part of the property, you must sell the whole. That would mean that even when you need only a fraction of the property value, you have to sell the entire property, which would mean all the costs related to transaction would apply to the full transaction amount. In fact, once you have sold the property and taken out the required amount of money, what would you do with the balance amount? If you buy another property, please remember, there would be additional transaction cost on this. Such increased costs, at least, reduce the return on your investment. On top of this, the rental yields are extremely low for quite some time, and hence real estate investments are made only in the hope of price appreciation.Investment in property under construction: While investment in constructed property suffers from various issues as discussed above, that in a property under construction carries another additional risk – till the time the property is not ready and the titles are not transferred in your name, you are exposed to the risk of the builder’s technical and financial abilities to complete the project in time. While one may be technically sound, the same may not be true regarding financial ability at all times.
  4. Equity markets: Equity is believed to be offering high returns over long periods of time, but carries very high risk of volatility as well as being able to select good companies to buy the stocks at reasonable valuations. If you end up buying a bad company or if you buy a good company at hefty valuations, the future returns may be disappointing.

What should an investor do in such a case?

One has to start with the understanding that as the overall interest rates in the economy have come down, the future returns from almost all the safe products would be lower than what one enjoyed in the past. Also, it is important to remind one of the risk-reward relationship we mentioned earlier.

Consider liquid funds and debt funds if you want to transfer money from your savings accounts, current accounts or bank deposits into another investment. The advantages of the liquid and debts can be summed up as:

  1. Professional management: Here is an investment management team that has the time and ability to analyse various investment options before adding to or removing from the fund’s portfolio.
  2. Diversified portfolio: As per SEBI regulations, a mutual fund cannot invest more than 10% of the fund into any issuer’s debentures, except those of the Government. This would offer a portfolio where the risk of individual company is restricted to 10%.
  3. Tax efficiency: Mutual fund investments offer great tax-efficiency as compared to any other debt investment. If one invests for period longer than 3 years, the capital gains are considered long term and taxed at lower rates.
  4. Great liquidity and flexibility: If the investment horizon is uncertain, or part of the money may be required for any purpose, there is no investment that can match the liquidity and convenience of open-ended mutual funds, except savings bank account or current account. One can invest any amount for any period, withdraw partially or fully, add more funds to the folio multiple times, etc.

Considering these benefits, one may look at liquid mutual funds if the time horizon is short – the returns could be higher than short term bank deposits, the time horizon may be unfixed and the risks are far lower than some of the options mentioned earlier. If the time horizon is long, there are various other choices from the mutual fund stable.

So, go ahead and take the advantage of mutual fund investments that offer better risk-managed investment returns.

Written by

Vedant Kaushik