Investment

Will RBI’s floating rate savings bonds 2020 give you a positive real return? Here’s the math

By Dr. Neelam Rani and Prudhvi Sankar

RBI’s Floating Rate Savings Bonds 2020 are bonds issued by the Government of India, with an interest rate of 7.15 percent. The interest rate on these bonds will be reset every six months (mentioned below). The bonds have been made available for subscription on July 1, 2020, and you can invest in these bonds through public sector banks and select private sector banks like HDFC Bank, Axis Bank, ICICI Bank, and IDBI Bank. RBI has already opened up the subscriptions for the Bonds through the permitted 16 Banks.

The bonds are issued only in electronic form and held in the Bond Ledger Account (BLA). The BLA is an account with RBI or an agency bank in which the bonds are held. The investor, in this case, receives a Certificate of Holding from RBI/Agency Banks.

Key features of the Bonds

  • The Bonds are open for subscription by Resident individuals and HUFs. Individuals can invest in the bonds in individual capacity or on joint basis.
  • The Bonds carry a floating rate of interest that is reset every six months with the first reset falling on Jan 01, 2021. The payouts from the Bond are made semi-annually on Jan 01 and July 01 every year.
  • Investments can be made in multiples of Rs.1000 with a minimum of Rs.1000. There is no ceiling on the maximum amount that can be invested in the Bonds.
  • The Bonds carry a floating rate of interest that is computed as 0.35% (i.e., 35 bps) over the reference rate of prevailing interest rate of National Savings Certificates (NSC). The interest rate on the NSC, is in-turn linked to the yield on 5-year / 10-year government securities and is reset by the Government on quarterly basis. It implies that the market rate ultimately plays a role in determining the floating interest rate of the current bonds. The NSC interest rates are notified by the Government on quarterly basis.
  • The Bonds have a fixed tenure of 7 years. However, premature withdrawals are permitted (only to individual investors) subject to a minimum lock-in period that is based on the age of the holder.
Age bracket of the individual investor Lock-in period from the date of issue
From 60 – 70 years 6 years
From 70 – 80 years 5 years
80 years and above 4 years

In cases of premature encashment, 50% of the interest due in the last six months of the holding period is recovered from the proceeds and the proceeds are paid out at the next interest payment date.

  • The Bonds do not carry any benefits under the Income Tax Act and the interest income is fully taxable.

Let’s take a closer look at these bonds by evaluating the pros and cons. Should you invest in floating rate savings bonds?
Advantages
High interest rates: The attractive feature of the Bonds is clearly the higher interest rates. The Bonds offer a high interest rate by design, as the interest rate is set at 35 bps higher than the NSC prevailing rates. The prevailing NSC rate is 6.8%, which effectively sets the interest rate of the Bonds at 7.15% for the first six months. The interest rates are re-set half-yearly, and the current interest rate on the Bonds is higher when compared to other investment options like the NSC (currently 6.8%), Fixed Deposits with Banks, Public Provident Fund (currently 7.1%).

Floating interest rate : The interest rate on the Bonds is based on the floating rate system. The floating interest rates ensures that the investors receive interest based on the interest rates in the market or rather the interest rate being offered on NSC. In case of rising interest rates, the benefits can be expected to be passed on to the investors but, remember the interest reset period is 6 months and the rate will increase only when the NSC interest rate increases.

Risk free investment option: The Bonds are risk-free as it is offered by the Government of India. Thus, the Floating Rate Savings Bonds provides another investment option for the risk averse investors and for investors seeking to diversify their portfolio.

Fixed income : The Investors will receive a periodical and regular income from the Bonds in form of interest pay-outs. This leaves the Investors a choice to use their income, either for savings or for consumption.

Disadvantages
Taxable bonds : The tax exemptions and deductions are one of the key considerations for an investor to choose an investment option. The current Bonds do not carry any sort of tax benefits, either in the form of deductions under Chapter VI A of the Income Tax Act, or any exemptions for the interest income from the Bonds. The lack of tax benefits for the Bonds makes it relatively less attractive for the tax paying investors who are already using other alternative investment options.

Interest rate risks : Since the Bonds carry a floating interest rate and the interest rates are reset periodically, the investors are exposed to the interest rate risk. Interest rate risk, is the risk resulting from sliding interest rates. In the current times of COVID impact and expectations of low growth, the interest rate risk is expected to stay for a while.

Non-cumulative : The interest from the Bonds is paid out periodically to the investors and there is no option for cumulative interest. The passive investors may lose out on the compounding effect of the interest amount that is paid out to the investors.

Illiquidity : Restrictions on transferability (except in the event of death of the Holder), the lock-in period criteria for premature withdrawals, and the non-tradability of the Bonds makes them illiquid. Further, the investors cannot avail any loans from financial institutions (both Banks and NBFCs) with the Bonds as collateral.

Conclusion
So for whom will these bonds be a suitable investment?
As these bonds offer a floating rate of interest which would be reset as explained above, investors can expect the returns from the Bonds would be able to beat the inflation in the long-run. However, the taxability of the Bond remains a key consideration for the investors.

These bonds can be considered for investment by all those investors for whom the real rate of return from these bonds i.e. return net of inflation and taxes, is positive. As inflation is variable therefore the real return may vary over time for all investors.

Below is an analysis of the suitability of these bonds-based on current real rate of return and tax rates—for different investor groups.

In order to understand the impact of inflation and tax rates on the half-yearly interest payments, a sensitivity analysis is made.

Analysis captures the sensitivity of the half-yearly return (for a single half-year period) to the interest rate on current bonds, inflation and tax rates.

For easy of calculation, the interest rate on bonds and inflation rate are netted to arrive at ‘Interest over average inflation’ (positive is beneficial for the investors).

Interest on Floating Rate Savings Bonds (applicable for current half-year) a 7.15%
Current CPI Inflation b 6.09%
Interest over inflation (positive is beneficial for the Investors) a-b 1.06%

Based on the individual tax rates under the existing regime, the tax rates of 0%, 5%, 20% and 30% are considered for the analysis.

rbi

The area highlighted in red, indicates the zone that needs to be avoided. On the other hand, if my tax rate is 10% and the Interest(-)Inflation rate is 1%, the Bonds could be attractive for an investor.

While evaluating the suitability of these bonds, the investor must keep in mind that while the inflation rate is currently over 6% this may not always remain so-inflation has varied between 1.97% and 7.59% over the last 3 years.

The summary of the above analysis is below:

Applicable tax rate*
0% Tax will not have impact.
5% Real return will be positive if the expected spread of ‘Interest rate (-) CPI Inflation’ is at least 0.4%
20% Real return will be positive if the expected spread of ‘Interest rate (-) CPI Inflation’ is at least 1.5%
30% Real return will be positive if the expected spread of ‘Interest rate (-) CPI Inflation’ is at least2.2 %

Note: The above analysis is just for educational purposes and not for any advisory purposes. The actual analysis may vary when other details like surcharges and cess are considered.

(Dr. Neelam Rani is an Associate Professor (Finance) at Indian Institute of management Shillong. Prudhvi Sankar is a CA and alumnus of IIM Shillong.)

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