EPF interest rate, bond spread at 16-year high

Bond yield drop may make it tough for EPFO to keep interest rate at 8.5%

As interest rates in India trend lower, the spread between the interest rate on employee provident fund (EPF) and 10-year government bonds has reached a 16-year high of 2.5 per cent or 250 basis points (bps). One basis point is one-hundredth of a per cent.

The EPF interest rate for financial year 2019-20 (FY20) was 8.5 per cent, against a 6 per cent yield on 10-year government bonds. The EPF interest rate has exceeded yields on 10-year government bonds by 130 bps on average since 1971. So, the current spread is about twice the historical average.

According to experts, the sharp decline in bond yields will make it tough for the Employee Provident Fund Organisation (EPFO) to keep the interest rate at 8.5 per cent.

“When the general interest rate has come down, it has to be seen for how long EPFO can maintain interest rate at 8.5 per cent,” says Devendra Pant, head economist at India Ratings & Research.

Last week, EPFO said it will only pay 8.15 per cent interest to its members for FY20, and the remaining 35 bps will be paid by December.

“A sharp decline would hit EPFO earnings on fresh investments, but it has large portfolio of older investments made 6-7 years ago, when bond yields were hovering around 8.5 per cent. The net impact on EPFO earnings will depend on the break-up of old and new investments,” says Madan Sabnavis, chief economist at CARE Ratings.

There is a close historical correspondence between yields from treasury bonds and EPF interest rates. For example, EPFO paid 12 per cent interest in the 1990s, when bond yields hovered in the of 10-13 per cent range, according to data from the Reserve Bank of India.

The EPFO has a large corpus of retirement money that is augmented every year through new contributions. The majority of the accruing sums (90 per cent) every year is invested in debt instruments — bonds sold by public sector undertakings (PSUS), including some private sector bonds (30 per cent in FY17), central government securities (21 per cent), and state development loans (26 per cent).

The yields on all debt instruments closely follow the trajectory of the yields on 10-year government of India bonds. For example, state government bonds with 10-year maturity currently yield 6.65 per cent, while 10year Aaa-rated corporate bonds are trading at 6.9 per cent, against 6 per cent yield on 10-year treasury bonds.

The EPFO also forayed into equity investments in 2015, but the share of such investments was capped at five per cent annually.

In 2016, this limit was raised to 10 per cent, which the EPFO now invests in exchange-traded funds (ETFS). The benchmark indices, however, have provided annualised returns of only 6.2 per cent over these past five years.

The current divergence between the EPF interest rate and bond yields is of significance because the EPFO earns a surplus if its interest rate is lower than the long-term interest rates on debt instruments.

However, if the reverse is the case, the EPFO might have to pay from its surpluses accrued over time.

Analysts say, in the short-term EPFO can manage to pay a higher interest rate thanks to a large portfolio of older bonds.

“EPFO has a large portfolio of government papers that yield as much as 9 per cent, which it accumulated during 2011-2015. These will start maturing next year. As it holds all debt papers till their maturity, the EPFO is still earning well above 8.5 per cent on a significant portion of its portfolio,” says a fund manager.