Even if bank FD rates fall, high returns can still be ensured elsewhere.
While the prospect of further rate cuts by the RBI are boosting sentiments in the stock and bond markets, it is also making traditional fixed income investors nervous. Sooner or later banks and other institutions will bring down the rates on offer, signalling an end to near double-digit rates you are enjoying on various deposits at present. But there are ways to side step the rate cuts and continue enjoying higher returns for some more time.
Lend to corporates
While bank fixed deposits and recurring deposits would be the obvious choice for many, those with a slightly higher risk appetite and looking for a higher yield may opt for any of the corporate fixed deposits or debentures available. Experts reckon investors can lock in to current high yields before rates on these instruments also start going down. In the midst of falling interest rates, you may not get such opportunities for a while. For instance, investors can get anywhere between a 50200 bps (0.5%-2%) higher yield on the range of company FDs, compared to traditional bank fixed deposits. Fixed deposits from non-banking finance companies (NBFCs) are offering 9.5% to 11% for three year tenure under the non-cumulative interest pay out option (See chart). Certain manufacturing companies are offering slightly higher coupon rates, in the region of 12% on three-year fixed deposits. The interest earned on these company deposits is taxable at the rate applicable to your income tax slab.
If corporate FDs are not your cup of tea, you may consider putting your money in non-convertible debentures. Although there are hardly any fresh issues in the market currently, you can purchase any of the existing instruments listed on the stock exchange. Make sure to invest only in those instruments which are not maturing within the next one or two years. Since rates are expected to fall quite a bit in the coming year, opting for a NCD which will mature only 12-18 months from now will expose you to reinvestment risk, where you will be forced to park the maturity proceeds at a lower rate. For instance, Shriram Transport Finance NY bonds offering a coupon rate of 11.25% under the cumulative pay out option has a residual maturity of 1.52 years. The yield-to-maturity (YTM) on these bonds is 10.6%. On the other hand, the Shriram Transport Finance NU bonds with same coupon have a residual maturity of 2.55 years. They are currently offering a YTM of 10.72%.
A big benefit of opting for NCDs is the possibility of capital appreciation in these instruments as the rates fall. This offers you a chance to sell them at a profit, instead of holding on to them till maturity. With bond yields likely to come off by 1-1.5% in the coming months, investors could fetch decent capital gains on their NCD holdings. Besides, NCDs are a tax-efficient option as these are eligible for long term capital gains after one year. This means your gains will be taxed at a lower rate of 10% instead of at the rate corresponding to your income tax slab. However, the interest earned on these NCDs will be taxable as per the tax slab of the investor. Keep in mind though that these NCDs are not easily tradeable despite being listed on the exchanges. Liquidity can become a constraint for retail investors in NCDs. The trading volumes in some cases are very low, which makes it difficult for the buyer or seller to enter or exit at the desired price point. So you may end up buying at a higher price and selling at a much lower price than what you were looking for.
Credit quality is crucial
In both cases, investors must give due importance to the credit quality of the issuer. While your bank fixed deposits offer the highest degree of safety, company FDs and NCDs carry a much higher degree of risk as these are unsecured instruments. Invest only if you are convinced that the issuing company's financials are strong. Do not get swayed by the higher yield. Ensure the company's business model and financials are on a strong footing. This can be gauged from the credit rating assigned to the paper by the rating agency. AAA' or similar rated papers offer highest degree of safety, but fetch lower return. `AA' and lower rated papers come with attractive coupon rates, but imply a higher degree of risk.
Investors need to be careful especially when dealing with some lesser known names in the manufacturing space. You may take a call on lower quality paper provided you are dealing with marquee names in the manufacturing space, which boast of sustainable business.
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