The Centre's New Year gift of Rs 8,000 crore (Rs 80 billion) in interest on the Special Deposit Scheme to provident funds has left them stumped.

The funds cannot invest the money to avail of the 9-9.5 per cent interest rate on their SDS investment.

They are allowed to invest only in corporate debt or government securities, and interest rates on debt instruments are ruling at 5.80-6.50 per cent, over 150 basis points lower than the interest rate on the SDS.

The Reserve Bank of India has directed banks to pay interest on the SDS as on January 1, 2004, following a circular from the Centre asking it to credit PF accounts with 8 per cent interest on the scheme.

The State Bank of India, among other banks, has issued post-dated pay orders to its PF accounts.

The SDS was closed in 1977 and the interest on its deposits was so far reinvested in the scheme. For the first time, PFs are receiving the interest in cash.

The interest rate on the SDS has been coming down over the years, from as high as 12 per cent in 1998 to 8 per cent now.

Many old PFs have as much as 70-75 per cent of their corpus invested in the scheme. They will be hit the hardest. Newly formed funds will be less affected because just 3-5 per cent of their portfolio is invested in the SDS.

PFs invest around Rs 20,000 crore (Rs 200 billion) every year in the debt market in accordance with the investment norms laid down by the government.

Falling interest rates are driving some better managed PFs to look at secondary market investments, where the yields are higher and the differential works out to 50-100 basis points.

With the Securities and Exchange Board of India saying companies must list their debt instruments, fresh debt issues have dried up. So PFs will have little option but to invest in secondary paper.

Also, triple A-rated corporate paper does not offer more than 6.3 per cent interest. Primary market issues are being priced lower than their previous issues in recent times.

For instance, Power Finance Corporation's five-year paper issued in September 2002 carried a coupon rate of 7.5 per cent. In August 2003, a same tenor paper issued by it carried a coupon rate of 5.85 per cent.

Yields on government paper are ruling at 5.9-6.0 per cent. An issue of Rs 5,000 crore (Rs 50 billion) 7.38 per cent 2015 government securities will be auctioned on January 6.

The next day, the RBI will conduct an open market operation for an additional Rs 5,000 crore 5.87 per cent 2022 paper.

However, yields on 12-year paper and 19-year paper are today ruling in the secondary market at 5.3 per cent and 5.9 per cent, respectively.