PPF interest rate expected to fall further. Here's why

Last week, the government reduced the interest rate on public provident fund (PPF), one of its most popular small savings schemes, by 10 basis points to 8 per cent. 

Although the reduction was marginal, experts feel that PPF rates are slated to go down further. It could well go below 8 per cent - a level unseen since 1980.

"There is a defined formula based on which the interest rate on small saving schemes such as PPF is calculated. If one goes by that formula the interest rate on PPF should be reduced substantially," says Manoj Nagpal, CEO of Outlook Asia Capital, a consulting and wealth management firm.

The new rule came into effect on April 1 this year. As per the new formula, interest rate on small savings schemes is market-determined based on the previous three-month yields of the government securities of the corresponding maturities with a small mark-up. In case of PPF, the mark up is 0.25 per cent. Now, the interest rate on small savings schemes is reviewed every quarter, unlike earlier when it was set every year by the government.

If the government implements this new formula, the interest rate on PPF should be around 7.50 per cent, according to Nagpal.

The yield of the 10-year benchmark papers are hovering around 6.7 per cent - a multi-year low. After the repo rate cut of 25 basis points (100 basis points is equal to one per cent) early this week, the yield of benchmark government debt papers slipped roughly 10 basis points to 6.67 per cent. This implies that the market is expecting more rate cuts in future.

Nagpal says it is unlikely that the RBI will cut the repo rate in the December monetary policy review ahead of the Fed's meeting. But he expects the RBI to cut the repo rates by another 25 basis points after that.

In line with the fall in bond yields, the government may consider lowering the small saving rates further.

Nagpal is of the view that the government may not lower the small savings rate in the next quarter, but post Budget, it is likely that the small savings rate will go down further.

What should investors do?

Apart from the fixed-guaranteed return, PPF also enjoys the exempt-exempt-exempt tax status. It means the contributions, interest incomes as well as withdrawals are exempt from tax. So, the experts' take is that given the tax status, PPF will continue to remain an attractive choice for investors.