Fenil's Library

A sharp drop in interest rates is almost a certainty now

Sandeep Shanbhag

The rate of inflation should decline to zero sometime in the next six months, going by the chief economist of a leading private sector bank I was talking to the other day. Part of it would be due to the high base effect, of course, but an equally significant part would be on account of the sharp decline in prices of almost all commodities, especially of oil, which augurs well with regard to the inflation expectation of a commodity importing country such as ours.

With inflation no longer a threat, the government can pull out all stops to encourage growth and limit the collateral damage the recession-ravaged West can wreak on our economy. Indeed, the ball is already in play.

Last week, the Centre and the Reserve Bank of India (RBI) announced a coordinated stimulus package - monetary easing complemented with fiscal sops is expected to release a huge amount of liquidity that would hopefully ease the flow of funds through the financial pipelines of our economy.

Key amongst the various measures announced were a cut in the rate at which banks borrow from the RBI (repo rate) to the lowest ever of 5%. Simultaneously, the rate which RBI pays banks to park their idle funds (reverse repo rate) was also slashed to 4%, thereby sending a very strong signal to banks that the RBI is going to systematically disincentivise them from using it as a safe-keeper of their money. With bond yields dipping to as low as 4.86%, banks spooked by counter party risk will at last be forced to use their assets for productive purposes such as lending, thereby kick-starting the credit cycle in the economy. At the same time, the cash reserve ratio, which is the share of deposits that banks need to park with the RBI, has been brought down in five successive cuts to 5%. The aggregate liquidity that has been released into the system due to monetary actions undertaken so far is expected to be in the region of Rs 3 lakh crore.

What does all this mean for us retail investors?

Well, first and foremost, it is almost a given that such strong measures will without any doubt see a sharp drop in interest rates. In fact, K V Kamath of ICICI Bank has gone on record saying he expects interest rates to fall up to 5 percentage points over the next six months. Therefore, investors who intend to park their money in bank deposits should hurry, if they haven't invested already.

With bank deposit rates coming off, alternate investments such as company fixed deposits (FDs) would suddenly start seeming attractive.

Though monetary policy is being eased, some corporates, especially in the real estate and construction sectors, would find raising money from traditional sources difficult. Offering the retail investor a higher rate on corporate FD would be the immediate recourse adopted and it is here that a retail investor should take care. An attempt to earn marginally higher return could well prove to be one in which the capital itself may get unstuck. Realise that company FDs are unsecured loans and not subject to a charge on the fixed assets of the company concerned. There is a reason why banks are chary of lending to corporates and investors must undertake the necessary due diligence.

If I were you, I would prefer to put my money in gilt and long-term bond funds. Over the next 12 months or so, this is the space that offers the highest potential for safe yet attractive returns.

This is because interest rates and prices of fixed income instruments share an inverse relationship. When the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa.

To illustrate how fluctuations in interest rates affect the returns, let us take the example of an income fund.

We assume that the current NAV of the fund is Rs 10 and its corpus is Rs 1,000 crore. This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all the unit holders, they will receive Rs 10 per unit.

Now, suppose the interest rate falls from 10% to 9%. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs 1 lakh at the lower rate of 9%. This is injustice to the existing investors. Therefore, something has got to be done to protect their interest.

Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The return on 9,000 units @10% would be identical to the return on 10,000 units @9%.

In other words, the NAV rises when the interest rates fall.

Indeed, this has already started happening and the one-year return on most funds is already in the region of around 20% p.a. Going ahead, as the yield on government securities has already come off substantially, funds investing in corporate bonds as against gilts are expected to earn better return. The credit spread between gilts and corporate bonds still exists and a 15% annual return in a well-managed income fund of a good pedigree would be a very reasonable expectation.

sandeep.shanbhag@gmail.com