The interest rate offered on Public Provident Fund (PPF) was 12% p.a. from April 1986 to January 2000, that too tax free. Post this, the interest rate on PPF and other small saving instruments have seen a declining trend. On 18^th March 2016, the Government announced another cut in interest rates on all small savings wherein PPF rates dropped from 8.7% to 8.1% effective April 1, 2016. Thus, over the past 16 years, PPF interest rates have seen a drop by about 4%. To get the right perspective of this drop, let us assume hypothetically that one had invested Rs.1 lakh every year for 15 years in PPF at 12% p.a. and one at 8.1% p.a. in two separate accounts. The maturity amounts after 15 years would have been approximately Rs.42 lakhs and Rs.30 lakhs respectively (assuming the interest rates were the same throughout the tenure). The difference is a whopping Rs.12 lakhs owing to a 4% change in interest rates. While in reality, the drop in interest rates has been gradual, the example helps us realise the impact of wealth erosion in traditional assured returns products owing to a decline in interest rates over the long run.

With the government and RBI aiming to reduce the cost of borrowing for industries in order to provide greater momentum to economic growth, one may see more interest rate declines over the long run. Of course, this has various caveats like inflation rate, situation of the monsoon, food prices in the country, foreign capital flows, global macro situation, etc.

Let us look at the example of USA which has undergone this cycle of declining interest rates over the long run. Not many would be aware that 10-year US government bonds carried double digit yields in the early 1980s (10-15%), similar to high interest rates in India in the 90s. As the US progressed and its household wealth grew, interest rates slowly started declining with 10-year yields closing at 6% levels in the 90s, at 3% levels in 2010 and currently hovering slightly below 2%. (Source: http://bit.ly/1UVTwQC). However, as interest rates declined, the investment trend of US investors showed a migration towards market linked products like mutual funds given their potential to offer relatively higher returns. As of 2015, about 43% of US households own mutual funds vis-à-vis 5.7% in 1980 and 29% in 1995 with almost 90% of mutual fund assets being held by retail investors as of 2015 (Source :  www.ici.org).

Like in the US, Indian investors too may look at including market linked products like mutual funds in their investment basket to help reduce the impact of interest rate declines. We are still a drop in the ocean vis-à-vis the US mutual fund industry with less than 5% Indians (by folio count) owning mutual funds (Source: AMFI as of March 2016). Potential investors may also wish to take a cue from the Indian government which recently started investing 5% of the Employees Provident Fund’s (EPF) incremental corpus in equity mutual funds to benefit from their relatively higher returns potential. The equity proportion may increase to 15% over the short to medium term as suggested by the Finance Ministry. Just like the baby steps taken by the EPF, one can start a small ‘SIP’ (Systematic Investment Plan) in a mutual fund for just Rs.500 per month and aim to benefit from its long term wealth creation potential.

Information contained in this article is not a complete representation of every material fact and is for informational purposes only. The recipient is advised to consult its advisor/ tax consultant prior to arriving at any investment decision.