About Fixed Deposits
The Reserve Bank of India has raised key policy rates (interest rates), repo rates and reverse repo rates to bring down the rising inflation. This is the 11th rate hike in the past 17 months (2010-2011) .
The RBI raises interest rates if the inflation rises and this will make the Banks to raise the interest in fixed deposits.
Banks Fixed Deposits are not completely Risk Free
The only risk that most depositors are aware of is the failure on the part of the bank to allow depositors to redeem their investment on maturity. But again, deposits of up to . 1 lakh are insured. Therefore, investments of . 1 lakh or less are defaultproof.
However, there is another risk that depositors are either not aware of or ignore — the reinvestment risk. This refers to the possibility that, if the interest rate cycle were to turn, you may have to settle for a lower rate of interest when your deposit comes up for renewal. That is assuming that you would not need the money then and, hence, would prefer to extend the tenure of the investment. “The reinvestment risk will always be there. You may be able to earn good returns on your fixed deposit for a period of say one year, but, after that, the interest rate offered could be lower .
Short term and Long term
Usually, rates on short-term fixed deposits of 1-2 years are higher than on deposits with tenures of 3-5 years and beyond. Understandably, the tendency among individuals is to lap up shorter-maturity deposits, since the yield is higher and also the lock-in period is shorter, cutting down the wait involved. out. It’s thus clear that the RBI will continue on this path unless a clearly sustainable downturn in inflation is seen. Against this backdrop, investors in FD products seem to be going with the flow by locking in higher short-term rates than the lower long-term rates.”
At present, the interest rate on a one-year fixed deposit is hovering around 9.25% per annum. For longer-term deposits of 3-5 years, the rates are in range of 8.25% to 9.25%. Choosing between the two may seem like a straightforward decision to make, but it may not be as simple as it seems.
(Updated - 26 Nov 2011)
Fixed Deposit Renewal Risk
There is always the reinvestment risk in FDs. Investors may not get the opportunity to invest at the same rate after one or two years when their FDs come up for renewal. It is possible that the interest rate available at that point of time is lower than the interest rate applicable now on long-term deposits. If the current difference between the two is only 1%, then it would be always better to lock your deposit for the longer term provided liquidity is not a concern.
The following table shows the fixed deposit rates for short term and long term.
Investors should choose the term depending on their investment horizon and objective of their investment.
Your asset allocation and goals, therefore, hold the key. Investors in bank FDs would do well to start looking at longer-term deposits now as we may be extremely close to the level where the short-term rates may start coming down and then these investors will not be able to roll over their FDs at high rates .
Those investors who are moving money into debt from other assets as a tactical move due to the equity and real estate markets being non-starters would do good to stick to one-year bank FDs/debt products so that they have the liquidity to move back when opportunities arise. Investors with a higher risk appetite should stick to one-year terms even for longerterm debt allocations, as there will be more profitable debt strategies emerging once the rate cycle turns.
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