FD investors should use this formula to get maximum benefit from rising interest rates

During the last 10 years fixed deposit (FD) investors saw their returns declining by 40% from the highest interest rate level of 9% offered by in September 2014 to 5.4% in May 2020. Decadal low FD interest rates was a cause of huge financial stress for people like senior citizens whose primary source of regular income comes from FDs. Nevertheless, ultimately there are signs of good days ahead, as banks and other financial institutions have started to increase FD interest rates, albeit marginally.

However, future is not less challenging. Even though the direction of interest rate has reversed, however, nobody is sure where the rates will finally reach and how long will it take for interest rates to peak. If you wait longer to book your FD for a higher rate you will end up losing on current growing rates and if you book long-term FDs after only a few hikes, you may end up at the losing end if the rates keep growing later. We tell you how the interest rate is likely to move and how you can make the best out of the unfolding situation.

Will FD interest rates breach 7%?

Whenever policy rates start going up it is the lending rates that see quicker transmission while the rate transmission is slower in FD rates. The repo rate was hiked by 0.40%, however, the deposit interest rate hike was typically lower.

“Most banks have hiked their deposit rates by 20-30 basis points after the repo hike. The expectation is that there will be hike to the tune of an additional 75 bps over the next couple of quarters, and while not all of it may be transmitted, depositors can expect rates to go up by another 40-50 bps. This would take it closer 7%,” says Adhil Shetty, CEO, BankBazaar.Com.

Possibility of interest on FDs rising to 8% in next 1-2 years

8% interest is considered to be a decent return by a good number of FD investors. So how likely is the possibility of deposit rates reaching that level? “There is no doubt that the interest rate on deposits will increase. We expect it to increase by 100 to 150 bps in the coming two to three quarters. The rates are expected to come back to pre-Covid days in this period. While it is not easy to say it can increase to 8% in the coming year or so. The last time such a rise has happened in 2010 to 2012 after the Lehman Crisis,” Harshad Chetanwala, founder, My Wealth Growth, a wealth management company based in Mumbai.

The current situation is also extraordinary in many ways due to the Covid-19 pandemic related liquidity infusion and hyperinflation led by the Russia-Ukraine war. So, the FD interest rates touching the 8% mark is a possibility. “Interest rate on deposits is linked to the repo rates in general. We see repo rates going up to about 6% within next one year and about 6.5% in next two years. With this, there is a good possibility of deposit rates going up to 8% in next two years,” says Col Sanjeev Govila (retd), Certified Financial Planner, CEO, Hum Fauji Initiatives.

As the momentum of the interest rate hike looks strong it is not farfetched to expect the interest rate to touch 8% soon. “Overall, the rates are expected to go up by 200 bps in the next two years. So, there’s a chance that rates may hit 8% for certain category of deposits,” says Shetty.

Short or long term, which tenure will rise first and the most?

When interest rates rise sharply the increase is not always evenly distributed. “The FD rates across all tenure have started increasing. Usually, it is the long-term FD that can see a higher increase in the interest rates compared to the short term at this stage. As the interest rate increases, we will continue to see these FDs offering better rates,” says Chetanwala.

Should one wait for rates to go up beyond 7% to book long term?

So, if you are looking to book an FD for the long term or a big FD is due for renewal, this may not be the right time to do so. “There is no reason for one to lock into long term rates now. We believe that the rate increase will be front loaded due to galloping inflation currently. Hence, it would be good to take short term auto renewing FD right now of about 6 months at a time,” says Govila.

“A six-month to one-year is an ideal time horizon if you have flexibility. I would suggest you choose the one-year tenure if you have to. Some people also could break it up into two 6 month FDs with a roll over option for a slightly better overall yield, considering we are in a situation of a rising interest rate scenario,” says Santosh Joseph, Founder and Managing Partner, Germinate Investor Services LLP.

“After about a year, a longer-term FD can be taken when scope for further increases is likely to be slower and limited,” says Govila.

Where to invest during waiting period before booking long term FDs

“Ideal would be carefully chosen Ultra Short-Term Mutual Funds where there is an automatic interest rate step-up as the rates rise with a typical time lag of about 4-5 months,” says Govila.

You can also consider parking your money with short term FDs as well. “One can consider parking their money in short term FD of up to 6 to 12 months, Ultrashort duration debt funds, low duration debt funds and floating rate debt funds,” says Chetanwala.

Is FD laddering a better option now?

Making an FD ladder is also an option as it helps you to break a big deposit into many parts and book each part after a time gap so that you get the average return and periodic liquidity when there is volatility in the interest rate. “FD laddering is a good concept for those investors who always keep a part of their portfolio in FDs. One can follow this concept very well for their contingency funds if they keep them parked in the bank account or FDs,” says Chetanwala.

However, choosing the right tenure and frequency of deposit is important. “Laddering FDs for the short term will give you periodic liquidity as well as the ability to move to a higher interest rate when you reinvest on maturity. So, booking short-term FDs and then reinvesting them for longer terms over the next few months would be a wise strategy,” says Shetty. For instance, if you have Rs 10 lakh you can the first FD of Rs 2.5 lakh for six months, then a second FD of Rs 2.5 lakh for 9 months and so on. Once your first FD matures you can increase the tenure to 2 years and after that once the second FD matures you can keep the tenure 2 years 3 months and so on. Once these FDs start maturing you increase the tenure to 3 years and increase the gap between the two FDs to 9 months.

The idea remains to keep the tenure short at present and increase the tenure with time as the interest rate increases. “Even in FD laddering one does invest a part of the money in longer duration deposits. This can be avoided at this stage and the investment can be split into low or medium duration FDs at present. The key in our view is to avoid locking the money in longer duration debt instruments,” says

Should you invest in RBI floating rate bond?

RBI floating rate bond is another good option to consider as these bonds are designed to pass on the interest rate hike benefit to depositors. “RBI floating rate bonds or even the floating rate funds are available, they are sort of hedge against this rising interest rate situation, but you have to remember that even these could be slightly more volatile due to reset and adjustments that the funds and the bonds will have to go through with the rate hike cycle,” says Joseph.

In the rising rate scenario, a floating rate deposit can be an apt investment. “These bonds are very attractive to those looking for a constant stream of income with capital protection. The biggest risk in such bonds is its illiquidity as the tenor is 7 years. In most cases, there is no option for premature withdrawals, and these bonds aren’t tradable or transferable. Also, the bonds are taxable, so they may not be the best choice for those in the high tax bracket,” says Shetty.

As this bond comes with a long lock-in period you should invest only an amount which you may not need for the locked in period. “RBI FRBs are recommended only if one is willing to stay invested for the long period of 7 years. In case of senior citizens too, up to 70 years of age, it is a minimum of 6 years lock-in. However, since RBI FRBs are linked to NSCs, even when the rate cycle reverses in this long period of lock-in, one can be reasonably assured that rates will not go too low. Eg, in the last two years, while the FD rates went down to historical lows, these FRBs remained at 7.15%,” says Govila.

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