The Small Savings Schemes Conundrum

After the December monetary policy review, the focus is on small savings schemes yet again. In what has become an increasingly familiar trend, the Reserve Bank of India (RBI) faulted banks for not passing on benefits of rate cuts to consumers (read cheaper loans). On their part, banks continue to maintain that rates offered by small savings schemes are rather high. Broadly speaking, banks compete with such schemes while raising monies (fixed deposits et al); hence, the cost of borrowing become high, which in turn translates into a higher cost of lending (read expensive loans).

There seems to be consensus on the need to ‘rationalise’ small savings schemes; simply put, small savings schemes need to be made less attractive (typically a lower rate) thereby enabling banks to borrow at an inexpensive rate, and so on. But then, rationalising small savings schemes is easier said than done.

To begin with, there are political implications. Small savings schemes are perceived as (and to a degree rightly so) the layman’s investment avenues. Any attempt to make them less attractive could politically hurt the government. While on one hand, they run the risk of losing favour with citizens, on the other, it is easy to visualize the opposition hurling more ‘suit-boot’ jibes at the government :)  

Furthermore, there is some truth in the theory that small savings schemes are like the proverbial ‘silver bullet’ for a bulk of the population. The combination of low minimum investment amounts, safety (assured returns and protection thanks to a sovereign guarantee) and availability (sold through a vast network of post-offices and branches of select banks), truly make small savings schemes the layman’s investment avenue. Hence, tampering too much won't be a prudent choice. 

Clearly, authorities will have to adopt a middle-of-the-road approach. Here are some thoughts on what could be done:

To begin with, schemes that are targeted at specific investor segments such as Senior Citizens Savings Scheme and Sukanya Samriddhi Accounts will be left unchanged.

There is a school of thought which maintains that Public Provident Fund (PPF) scheme must be suitably modified. The popular scheme received a boost in 2014-15 when the maximum investment limit was increased to Rs 150,000 per annum (versus Rs 100,000 earlier). But I will be surprised if the authorities decide to tinker with PPF. Let’s not forget that retirement planning is yet to find its due acceptance in the country, and PPF features among a handful of genuine long-term investment products available to investors.         

To my mind, the Post Office Monthly Income Scheme (POMIS) and Post Office Time Deposits (POTD) will be put under the scanner. As per data from the RBI, as of Feb 2015, Rs 2,010 billion was invested in POMIS. This amounts to roughly one-third of the total corpus in all small savings schemes. Admittedly, there is a need for investment avenues that yield regular assured returns. Then again, both private and public sector banks offer products comparable to POMIS.  What sets the two apart is the rate of return; while POMIS offers 8.4% per annum, similar products from banks offer annual returns ranging from 7.25%-7.75%. It’s quite likely that the authorities will want to address the disparity.

Another aspect which is no less important pertains to the investor segment benefiting from the POMIS. It is an open secret that several affluent individuals have utilised the upper limit of Rs 900,000 available under joint POMIS accounts. Additionally, the monthly returns are invested in a Post Office Recurring Deposit account to further augment returns. Authorities will be inclined to correct this lacuna as well, thereby enhancing the prospects of POMIS being rationalised.

Then there’s POTD, the fixed deposit equivalents from small savings schemes. These deposits are offered in tenures of 1-year, 2-years, 3-years and 5-years. There’s a stark disparity between POTD rates (ranging from 8.4% per annum to 8.5% per annum) and those offered by bank fixed deposits. The popularity of POTD can be gauged by the fact that as of Feb 2015, monies parked therein (Rs 508 billion) accounted for roughly 8% of total assets held under small savings schemes.

It can be safely stated that by modifying two schemes (POMIS and POTD) which attract a bulk of monies, and leaving others unchanged, the much-desired balance can be struck.

There’s a thinking in some quarters that the way to rationalise small savings schemes is by virtually dismantling the structure, thereby ensuring that monies flow into banking channels. Such thinking is flawed to say the least. The small savings schemes framework serves an important function of offering investment options to the lay investor in the farthest corner of the country. The need of the hour is to create a level playing field between small savings schemes and bank products.

Beware of investment advice which reads...

Markets are in a celebratory mood. Election results not only met but surpassed expectations with the BJP-led NDA gaining a thumping majority. With markets surging northwards, it comes as no surprise that the performance of mutual funds has started looking up too. Pick up any business daily, and you are likely to find articles extolling virtues of mutual funds, discussing their performance and favoured investment areas. And then, there are experts dishing out advice on what investors must do. While some of the advice is sage, there is also a lot of rather disconcerting advice doing the rounds. I have chosen three pieces of investment advice which are at best half-truths, and at worst completely incorrect.

1. Dynamic bond funds work like a silver bullet

Will the RBI governor cut rates in the forthcoming monetary policy review or won't he? That seems to be the million dollar question at the moment. And this in turn, has led to a lot of discussion regarding dynamic bond funds. Simply put, the latter have a fluid investment style wherein the manager takes active duration bets, based on his assessment of where interest rates are headed. The manager's flexibility to position the portfolio across the yield curve is seen as a silver bullet. Sadly, there is a difference between plying a flexible approach and being successful at it. There are enough instances of even skilled bond fund managers woefully misreading the direction of interest rates. 

A case in point was mid-2013 when RBI's steps to bolster the weakening rupee spooked debt markets; at a time when consensus suggested that rates would soften, they rose sharply. As a result, several managers who had positioned their bond fund portfolios for a softer interest rate regime were caught on the wrong foot. Don't get me wrong--I'm not suggesting that dynamic bond funds are without merit. All I'm saying is: don't think of them as a magic potion for all woes. Even conventional short-term bond funds (which admittedly operate in a narrower band of say one-three years) are capable of adding value to the portfolio. Don't dismiss seemingly plain-vanilla products (read short-term bond funds) in favour of dynamic bond based on a misconception.

2. If the manager follows a consistent approach, the fund will perform

To be fair, a consistently plied approach is a positive as it infuses predictability. But to suggest that the same in isolation is a surefire recipe for success is naive. It takes a lot more for the fund to succeed. To begin with, it helps to have a skilled portfolio manager who is playing to his strengths. As for the process, it needs to be a robust one which is executed with skill. 

To better understand this, consider a process that relies heavily on making the most of mispricing opportunities between the cash and derivatives markets, or one that results in a substantial structural bias for certain stocks/sectors, or one that relies solely on momentum to deliver. These are examples of processes that aren't inherently robust, and ones that will succeed only in specific market conditions. Their consistent application won't automatically make the fund better equipped to deliver. Execution is no less important: consider a process which is rooted in valuation-consciousness and a long-term orientation. The robustness of the process notwithstanding, should the manager keep getting snared in value traps due to poor execution, the consistent approach is likely to be of little help.

3. Evaluate funds based on their holding pattern in top 10 gaining stocks

This one's rather bizarre. If it wasn't bad enough that investors were being misled to evaluate the performance of equity funds over shorter time periods like 1-year and 3-years (with scant regard for the risk-adjusted return showing), now apparently whether or not the manager was invested in the top 10 gaining stocks is a parameter to consider. To my mind, this demonstrates a poor understanding of both--the working of a mutual fund and what one must expect from it.

Funds are run based on their investment mandate and the manager's investment philosophy. A number of parameters such as market capitalisation, nature and quality of business, and valuations, among several others come into play. An investment universe is drawn out and stocks chosen from therein. Though it would certainly help if the best performing stocks were to feature in the manager's picks, it is certainly not obligatory. Let's not forget that in a sharp market upturn, it is often speculative, high-beta fare that fares the best. And the latter need not be the kind of stocks that every manager wishes to invest in. 

Broadly speaking, the test of a manager and his strategy should be the ability to score over the fund's benchmark index and comparable peers over longer time frames (read at least five years) across the return and risk-adjusted return parameters. Whether or not the manager is invested in the top 10 stocks is of no consequence.

In conclusion, there’s a lot of investment advice available in public domain. Investors on their part would do well to be discerning and act on advice that is apt for them.

Will small savings schemes be rationalised?

Lately, several business dailies have been carrying reports suggesting that the rates offered by schemes from the small savings segment are up for review. Apparently, banks that have been nudged by the Reserve Bank of India (RBI) to cut lending rates have demanded a rationalisation in small savings schemes; the rationale being that attractive rates on the same prevent banks from lowering deposit rates. This in turn impacts their ability to reduce lending rates. A recently-appointed RBI deputy governor echoed similar views.

What are small savings schemes?
Small savings schemes are colloquially referred to as post office schemes. Broadly speaking, schemes like Public Provident Fund (PPF), National Savings Certificate (NSC), Kisan Vikas Patra (KVP), Post Office Monthly Income Scheme (POMIS) and the Senior Citizens Savings Scheme (SCSS), among others form the small savings segment. These schemes are backed by a sovereign guarantee, making them risk-free investments. Also, certain schemes offer tax benefits under Section 80C of the Income Tax Act.

The rationalisation saga
Reports of a rationalisation in the small savings segment have cropped up on several occasions over the past few years. Several panels and committees mandated by the central bank have recommended a more 'rational' structure. However, barring some cosmetic changes, the small savings segment has remained largely unchanged.

Incidentally, provisional figures (sourced from RBI's website) reveal that in 2008-09, inflows in the small savings segment grew after falling successively in the two previous financial years. It's not difficult to understand the reason for this phenomenon. The aforementioned time-frame coincided with a sharp downturn in equity markets; consequently investors smarting from heavy losses in equity and mutual fund investments chose to opt for 'safe' avenues. And investors' preference for small savings schemes in a time of adversity only bears testimony to their popularity.

Will the FM bite the bullet?
Come July 3, 2009 when the Union Budget is presented, will the FM announce a reduction in rates offered by small savings schemes? Your guess is as good as mine. However doing so would certainly qualify as a bona fide unpopular step. For instance let's consider a segment of investors like senior citizens and retirees who are largely dependent on income generated from investments. For such investors, POMIS and SCSS are 'bread and butter' investment avenues, given their need for safety of capital and assured income. Any reduction in interest rates on these avenues is unlikely to go down well with investors. Also, let's not forget that speculation is rife, that we are in store for a popular budget.

The 'middle of the road' approach
A more likely scenario seems one wherein interest rates on certain schemes will be altered, instead of 'across-the-board' changes. For instance, the PPF which runs over a 15-Yr period offers assured returns, however the interest rate (8% pa at present) is subject to change. Post Office Time Deposits (POTDs) offer an investment proposition similar to the one offered by bank fixed deposits. A reduction in interest rates on such schemes is unlikely to raise many eyebrows.

While reducing interest rates would be the direct approach to rationalisation, there are other ways as well. These would entail reducing the attractiveness of the schemes. For example, Section 80C benefits can be removed from some of the schemes. The investment tenure/lock-in can be enhanced, thereby forcing investors to stay invested for longer. Clearly, there's more than one way to rationalise the small savings segment.

What investors must do
For investors who were planning to invest in small savings schemes, now wouldn't be a bad time to get invested. This is especially true for avenues like NSC or POTDs wherein the rate of interest is locked at the time investment. This will ensure that the investments are immune to any subsequent change.

Without doubt, the small savings segment looks set to undergo an overhaul; as regards the magnitude of the same, only time will tell. However, few would dispute the role that small savings schemes can play, in terms of being the risk-free debt component in the portfolio. As always, investors would do well to judiciously select schemes that suit them the best.