Small savings rate cuts make banking & PSU debt funds attractive

Last week, SBI announced a reduction of interest rates on its fixed deposits by 20 basis points and now pays a maximum of 5.7%, and other banks are likely to announce a reduction in deposit rates soon. Investors looking for higher returns post the sharp cut of interest rates in small savings products and bank deposits by up to 140 basis points could turn to bank and PSU debt funds. These funds could give investors 6.5-7.5%, thereby helping them earn 50-150 basis points higher than small savings products. For those in the high tax bracket, if they hold these funds for more than three years, these products will also get indexation benefits, which will significantly improve the post-tax returns. Post the repo cut of 90 basis points by RBI, the government reduced interest rate on 1-, 2- and 3-year time deposits from 6.9% to 5.5% and on Public Provident Fund by 80 basis points to 7.1%.

Many funds have an average maturity of around three years and modified duration of fewer than three years. If interest rates head higher, your returns will be lower; if rates hold then there is reinvestment risk, and hence it would be prudent to exit at the right time rather than waiting for tax benefit

There is an element of safety in this category of funds as the constituents are banks and central PSUs which are backed by a sovereign guarantee. Given the uncertain environment, we are in, financial planners believe while investors who stay invested for three years will get indexation benefit, they should not invest with that objective only.

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