Lock in to FDs now or find other alternatives quickly

The higher than expected 50bps repo rate cut by the RBI will make banks re-price their deposit rates downward. The reason is that borrowing costs for banks in the overnight markets will be 50bps lower at around 8%, which is the repo rate and RBI has given banks leeway to access the MSF (Marginal Standing Facility) at 9% by letting them go below 2% of their SLR (Statutory Liquidity Ratio) limit.

Banks have to hold 24% of their deposits (NDTL or Net Demand and Time Liabilities) in government bonds as SLR. The banking system deposit base is around Rs 60 lakh crores. Banks are holding around 29% of their deposits in government bonds. Hence banks can technically borrowing 5% (the excess SLR) of Rs 60 lakh crores, which works out to around Rs 300,000 crores from the RBI at the repo rate of 8%. Banks can also borrow 2% of Rs 60 lakh crores, which works out Rs 1.2 lakh crores through the MSF window at 9%. Banks will not be worried about liquidity given the Rs 4.2 lakh crores leeway offered to them by RBI at 50bps lower rate of interest post the repo rate cut.

The easing policy signal given by the RBI through the repo rate cut coupled with access to liquidity will make banks lower their deposit rates. Banks by lowering deposit rates and keeping loan rates steady will increase their NIMs (Net Interest Margins). Higher NIM's will lead to higher profits for banks, which comes at the cost of lower rates of interest for depositors.

Fixed deposit (FD) investors should quickly lock on to FD rates before they are brought down. Investors should also increase the tenure of their FD's as they can then earn higher interest rates for a longer period of time.

FD investors should also look for alternative fixed income investments to counter the expected fall in deposit rates. Alternative investments include investing directly in fixed income securities issued by banks, Corporates and the Government of India or indirectly through fixed income mutual fund schemes.

The current yields on one year, two year, five year and ten year maturity AAA rated corporate bonds are 9.6%, 9.3%, 9.35% and 9.4% respectively and the yields are likely to come down on the back of easing policy rates and easing liquidity conditions. Fall in yields will also give capital gain benefits to investors leading to higher returns from investments in fixed income securities.

Government bond yields in the one year, two year, five year and ten year maturity segments are trading at levels of  8.3%, 8.3%, 8.35% and 8.4% respectively. The high borrowing program of the government will keep yields steady despite rate cuts, but yields will start trending down going forward leading to capital gains for investors.

Investors who cannot access the corporate bond and government securities market (Indian fixed income markets are not conducive for direct retail participation) should invest in mutual fund schemes that invest in fixed income securities. Investors looking to benefit from fall in corporate bond yields should invest in short term and long term income funds while investors looking to benefit from fall in government bond yields should invest in long term gilt funds.

Expected one year returns to investors if yields fall by 50bps in corporate bonds and government bonds will be around 9.5% post expenses in short term funds and around 11.5% in income funds. Government bond funds will generate around 11.5% as maturities in government bond funds are generally higher than income funds.

Source: http://www.moneycontrol.com/news/fixed-income-bank-deposits/lockto-fds-now-or-find-other-alternatives-quickly_694312.html