After a couple of years of dealing with low interest rates, there is a glimmer of hope for fixed deposit investors. With the Reserve Bank of India (RBI) upping its policy rate and with the likelihood of more hikes, banks have started raising interest rates payable on fixed deposits. But does it make sense to go for this investment option? Here is what you should know.
No meaningful rise
The interest rate increase announced by banks is nominal in nature, so far. Though lenders have been raising interest rates and you may see signs such as “Up to 50 basis points increase in interest rates”, it is being offered only on long-term fixed deposits, typically more than three years. The interest rates on fixed deposits of one or two years—the most used option—has gone up by just 10-30 basis points in most cases. This is nowhere near the 90 basis point hike in the repo rate effected by the RBI, and does not come close to beating the rate of inflation. Since the rate action by the central bank, one-year bond yields have jumped by around 100 basis points. “Sensing the rising interest rate cycle, secondary market yields have gone up significantly across tenures. Bank fixed deposits rates will take some time to go up,” says Joydeep Sen, corporate trainer, debt.
State Bank of India (SBI), for example, pays 5.3 percent rate of interest for one-year fixed deposits. A senior citizen gets 5.8 percent for the same. However, a treasury bill issued by the RBI and maturing in June 2023 offers a yield of 6.25 percent. Put simply, the bank fixed deposit rates are not yet meaningfully gone up, especially if we see the inflation at 7.04 percent.
Do not lock in now
Since we are in the initial phase of a rising rate cycle for bank fixed deposits, avoid getting into long-term fixed deposits just because they offer bit more than short term rates. For example, SBI offers 5.5 percent rate of interest on five year fixed deposit. Given the high rate of inflation, most bank fixed deposits are offering negative real yield—nominal rate of interest payable on bank fixed deposits minus the rate of inflation. Post-tax returns further go down, as interest received on bank fixed deposits is taxable in the hands of the investor.
Investors are better off looking at staggering their investments in fixed deposits or can ladder them up. “For bank fixed deposit investors, staying in cash hoping for rate hikes means less earning for the time being. Instead, it makes sense to invest in a mix of one-, two- and three-year fixed deposits taking into account your cash flows needs,” says Parul Maheshwari, a Mumbai-based certified financial planner. As the deposits mature, you get to redeploy your money at the interest rates prevailing then.
“If you have invested in a long-term fixed deposit when the interest rates were lower compared to what they are now, then compute the premature withdrawal penalty and take an informed decision to break such a deposit. Redeploy the funds gradually as interest rates rise,” says Vikram Dalal, founder and managing director, Synergee Capital Services. If you are keen on investing in bank fixed deposits, consider short-term bank deposits maturing in around one year.
Though experts advise either laddering or staying in short term fixed deposits, they however, recommend avoiding the fixed deposits of five years or more.
What else can work?
For fixed income investors open to other options, corporate fixed deposits with similar risk profile offer better returns. For example, Housing Development Finance Corporation (HDFC) offers 6.05 percent rate of interest for a 15-month fixed deposit, and HDFC Bank offers 5.35 percent for a similar tenure.
“Stick to fixed deposits issued by AAA-rated non-banking financial institutions. Do not go after fixed deposits with low ratings in search of higher rates, because the credit risk also goes up,” says Maheshwari. Stick to short-term company fixed deposits over long-term ones.
In a rising interest rate scenario, it is better to avoid companies with stretched balance sheets or poor fundamentals, as they may find it difficult to roll over their existing debt, even if they are willing to offer a higher rate of interest. Companies with high credit rating and strong balance sheets, however, do not face this issue.
“Savvy investors can also look at investing in short-term government securities as well as tax-free bonds depending on tax slabs of the investors, as these instruments offer attractive yields and there is little credit risk,” says Dalal.
As the interest income gets taxed in the hands of the investor, the individuals in high-income tax brackets may find it attractive to invest in tax-free bonds. Such bonds with residual maturity of around three years are quoting around 5.3 percent yield, which works out to 7.7 percent (pre-tax) yield for a person in the 30 percent tax bracket.
“Though tax-free bonds are relatively liquid on stock exchanges or in the secondary market, government securities should be bought with a view to hold to maturity, given uncertainty on liquidity in retail lots on RBI Retail Direct,” says Sen.Mutual fund schemes investing in short-duration papers, be it target maturity funds or the open-ended short duration funds, are also attractive for investors in high income tax brackets. But they need to match their investment timeframe with the duration of the fund. If interest rates rise further, there may be mark-to-market losses as well.