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The Reserve Bank of India (RBI) has recently made the decision to increase interest rates on savings bank accounts, much to the delight of bank customers who tend to leave substantial amounts of money sitting in these accounts.
While this means that customers will now earn an extra half percent on their savings accounts, the question that arises is whether or not these accounts are truly the best place to keep funds that will remain idle until they are spent or invested.
Typically, money flows into a savings account directly from your salary. A large portion of this money then goes towards paying off your housing EMI. The remaining balance is further reduced by checks issued for credit card payments, utility bills, SIP, and other expenses. Month after month, this balance continues to accumulate in your savings account, which currently offers a 4% interest rate to savers.
Previously, the interest on savings accounts was calculated based on the lowest amount in the account between the 10th of each month and the last business day of the month. The interest was then paid out to the account holder at the end of the quarter or half year. This means that customers now earn more on their savings accounts than they did a year ago. However, this raise in interest rates does not necessarily make savings accounts the ideal place to store idle funds.
One of the main advantages of a savings account is its liquidity. You have the ability to withdraw money whenever you want. However, there are other avenues that offer better returns than savings accounts, while still maintaining a reasonable level of liquidity. These avenues are known as liquid funds.
Liquid funds are mutual fund schemes that invest in call money markets and other fixed income securities with a maturity period of less than 91 days. On the other hand, liquid plus funds, also known as ultra short-term bond funds, are debt mutual funds where the fund manager invests in securities with more than 91 days’ residual maturity. Typically, instruments with longer terms offer higher yields. By including such instruments, liquid plus funds are able to achieve higher returns.
Fund managers prioritize liquidity and safety when constructing the portfolios of these funds, which ultimately makes them a safer place to park your money. Liquidity needs are fully met, as redemption requests submitted and time-stamped before the cut-off time are paid out the next day. This is also known as redemption on a T+1 basis.
Comparing the post-tax returns of savings accounts and liquid and liquid plus mutual funds reveals an interesting distinction. Joydeep Sen, senior vice-president of advisory desk-fixed income at BNP Paribas Wealth Management, explains that while a bank’s savings deposit account offers a 4% interest rate, ultra short-term funds provide even higher returns. From a post-tax perspective, the returns from ultra short-term funds are even more favorable. The dividend distribution tax for individual investors in such funds stands at 13.5%, whereas the interest earned on savings bank deposits is taxed at the marginal tax rate, which can be as high as 30.9% for those in the highest income bracket. According to Value Research, liquid funds returned 6.75% and liquid plus funds returned 6.82% over one year.
In the current interest rate climate, liquid funds outperform savings accounts. However, it remains to be seen how long this will hold true. The Reserve Bank of India has recently released a discussion paper on the deregulation of interest rates on savings accounts. The paper includes a chart that illustrates the recent history of savings account interest rates in comparison to other key rates. Clearly, the money market offers superior returns for very short-term investments than what savings accounts can provide. Only for a brief period in 2009 did savings account interest rates surpass the weighted average call rate. The credit analyst of a fund house points out that these low money market returns were a consequence of surplus liquidity resulting from the RBI’s rate cuts in response to the global economic crisis.
Money market rates are expected to remain high as the economy continues to grow. However, the short-term scenario is uncertain. Crude oil prices have remained strong for the past three months, and given the unpredictable geopolitical situation in oil-producing nations, it is unlikely that prices will decrease. Oil marketing companies face increasing under-recoveries, which has led to a rise in petrol prices. While diesel prices have not yet been affected, there is speculation that they too will increase in the near future. These factors are likely to push up inflation, leading the RBI to continue raising interest rates. Ramanathan K, CIO-single manager investments at ING Investment Management, predicts a 50 basis point increase in key interest rates over the next three to six months. Financial instruments with good credit ratings and a 90-day maturity currently offer an annualized yield in the range of 8.75% to 9.25%.
While liquid and liquid plus funds outperform savings accounts in terms of returns, it is important to consider other aspects when selecting a parking facility for your funds. A savings account allows for the issuance of checks, a convenience not available with mutual funds. For example, if you need to pay rent to your landlord, you would have to redeem your liquid fund units, wait for the proceeds to transfer to your savings account, and then write a check.
The operational aspects of investing in these funds also need to be taken into account. Money flows into a savings account through various transactions, such as salary deposits. This makes the savings account the default parking space for your money. However, if you wish to invest some of that money in mutual funds, you would need to either do it yourself or find an agent who can assist you.
Since liquid plus funds are only parked for short periods of time, transactions occur frequently. It may be difficult for individuals to find the time or keep track of such transactions. Additionally, offline agents typically do not offer assistance for these types of transactions, as they are not remunerative. The best option is to approach an online fund distributor or open an online account with a fund house, as this ensures seamless fund transfers.
Liquid and liquid plus funds can also be utilized to enhance returns on investments. Rajesh Krishnamoorthy, managing director of Fundsupermart.com, suggests opting for a systematic transfer plan instead of a systematic investment plan if you have a large amount of money to invest in equity. This approach combines the benefit of averaging in an equity fund with the higher returns of a liquid fund compared to a savings account.
Overall, liquid and liquid plus funds offer better returns than savings accounts, but it is important to consider various other factors when deciding where to park your funds.
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