Will PPF, SCSS lose sheen without tax benefits?

Will the absence of tax benefits make small savings schemes less attractive? Should investors in these schemes consider other options for their debt allocations? Read on to find out if you’ll need to tinker with your debt portfolios in view of the recent changes and the options before you.

Do small savings work without tax shield?

Small savings schemes, which give the twin advantages of a government guarantee and various tax benefits, have been the automatic choice for most investors for their debt portfolios. The Section 80C tax deduction benefit available on these products meant that their returns got an automatic boost, depending upon the income tax slab rate of the investor. For instance, for an investor in the 20% tax bracket, the effective yield on the National Savings Certificate (NSC), which provides deduction benefit on the investment amount as well as the interest reinvested under Section 80C, is 9.875%. But are some of the popular small savings schemes worth considering if the tax benefit is stripped off?

Senior Citizen Savings Scheme (SCSS) and Sukanya Samriddhi Yojana (SSY): Schemes like SCSS and SSY that are designed to give a higher return than comparable schemes and deposits of similar tenure and risk profile continue to be attractive options for investors looking for income in their retirement years or for accumulating the corpus for a goal, whether or not the tax benefits are availed. The interest earned on SCSS is also eligible for deduction under Section 80TTB up to ₹50,000 that adds to its attractiveness. “The deduction up to ₹1.5 lakh in the first year of making the investment may not have been that big an incentive for an investor looking to invest ₹15 lakh in a year in SCSS. The scheme provides the best combination of return and safety for a retired investor,” said Naveen Rego, certified financial planner and registered investment adviser, discounting the possibility that absence of tax deduction benefit will affect the popularity of SCSS among eligible investors.

Public Provident Fund (PPF): This, too, has been a favourite with investors in small savings schemes for the long-term compounding benefits it provides and the exemption from tax at all three stages of investment—at the time of making the investment, when interest is earned and on maturity—giving it the EEE (exempt-exempt-exempt) status. “In case of PPF, the exemption from tax on the interest earned gives a boost to long-term compounding and the corpus at maturity is also exempt from tax,” said Rego. He added that PPF will continue to be the best fixed-income product for risk-averse investors whether or not there is a tax benefit at the time of making the investment.

NSC: However, products like NSC may become less attractive without the tax benefits. Investors who used NSC for building an income ladder or to accumulate a corpus for short-term needs may be better off with other options. For example, the government of India’s 7.75% savings (taxable) bonds (read bit.ly/2ONPUT3 to know more about them) give marginally higher returns with the same sovereign guarantee. However, the bonds have a slightly longer tenure of seven years as compared to five years for NSC.

The caveat: What investors need to watch our for is the future trend in interest rates. Despite the move to make the returns on small savings schemes market-linked since 2016, the actual implementation has been patchy. The interest rates on the schemes are reset every quarter but the link to the yields of comparable government securities has not really been maintained. This is likely to change from the first quarter of financial year 2020-21, going by the signals coming from the finance ministry, when greater linkage with government security yields is expected.

A combination of abundant liquidity in the banking system, higher demand for government securities from banks as credit growth remains weak and the government’s efforts to maintain fiscal discipline may mean the government security yields may be in check. This will limit the possibility of earning a higher interest on small savings schemes, if they are strictly aligned to government security yields going forward.

Should you go for debt mutual funds instead?

Investors who are not hung up about guaranteed returns should consider investing in short-term debt funds that have good risk management in place for their goals that are three to five years away.

Specific debt funds are expected to benefit, thanks to a recent RBI announcement. In the last monetary policy committee meeting held on 6 February, 2020, RBI introduced long-term repo operation (LTRO), which is another tool to enable better monetary policy rate transmission. LTRO will allow banks to borrow for one- and three-year periods at the policy repo rate of 5.15%. “It gives banks committed money at the repo rate of 5.15% for one or three years. This move is expected to push short-term yields in the one-, three- and five-year spaces down,” said Arvind Chari, head, fixed income, Quantum Advisors Pvt. Ltd. The corporate bond yields are also likely to come down, he added.

“Debt funds that are positioned at the front end of the yield curve will benefit from this move,” said Chari. Short duration funds, dynamic funds that invest in bonds of similar tenures, corporate bond funds and bank and PSU funds are expected to benefit as yields come down and the price of existing bonds go up.

These are funds that investors should consider for their core portfolio for the competitive post-tax gains they generate. Long-term capital gains from debt funds are taxed at 20% but the tax payable comes down with the benefit of indexation, making them a good investment choice.

“Investors must be wary of chasing high YTMs (yields-to-maturity) and high returns in debt funds. They should instead evaluate the debt fund portfolio to understand the risks either on their own or work with an adviser who is able to do it for them,” said Rego.

The Bharat Bond Exchange-Traded Fund (ETF), which allows investors to tie in the yields at the time of making the investment if they hold to maturity, is a tax-efficient alternative for investors in bank fixed deposits (FDs), now that the Section 80C benefit on five-year FDs has also been made optional. With yields of 7.34% for the 10-year ETF and 6.37% for the three-year version, Bharat Bond ETF scores over bank FDs of similar tenors in terms of returns. Since they have a portfolio of government-backed bonds, the investors’ need for safety is also taken care of.

Unlike equity investments where mutual funds are the preferred vehicle for retail investors, for their debt allocations, investors first like to exhaust the traditional investment avenues that provide guaranteed returns before considering debt funds. With the tax shield coming off, many of these investments are now vulnerable on the return metric and this is where well-managed, high-quality and short-term funds can make their space in investors’ portfolio.