As central banks around the world, including in India, look to rekindle economies ravaged by the pandemic through monetary policy measures, interest rates are expected to remain low for perhaps the next couple of years. Seeking to stabilise the financial markets and stimulate the United States economy, the Federal Reserve last week reaffirmed plans to leave its benchmark interest rates pinned near zero until at least 2023.
In a situation of high inflation and declining interest rates, fixed deposits (FDs) with banks will have to take the backseat in an investor’s asset allocation, especially for those in the highest marginal tax bracket.
How should you view FDs?
Back in 1995, State Bank of India offered an interest rate of 13% on deposits of more than three years. It was an attractive offer, and the fact that income levels were low and most individuals fell in the lower tax brackets, meant double-digit returns post-tax. FDs were a low-risk, high-interest investment then; things have changed dramatically since.
Amar Pandit, founder of Happyness Factory, an online goal-based investing experience platform, said, “FDs are simply low-cost loans to banks, and should not be seen as an investment avenue.”
A quick calculation shows that FDs don’t make much investment sense for those in the high tax brackets, other than the fact that some old investors still derive comfort from investing in bank FDs. However, over the last couple of years, that comfort too, has been shaken — depositors have seen their deposits getting stuck, first in PMC Bank and then in Yes Bank, as RBI imposed a moratorium/ cap on withdrawals. Investors were reminded also that in case of default in FD maturity payments, their deposit insurance would cover payment only up to Rs 5 lakh.
Indeed, FDs no longer serve the purpose they did 20-25 years ago. “The purpose of any investment is to grow the value of assets over a period of time, but with the interest rates in the current scenario, and the high inflation — and for someone who falls in the highest tax bracket, it does not make much sense,” Pandit said. “For liquidity, individuals may keep some money in fixed deposits.”
But yes, those who are not required to pay tax, or who fall in the lowest tax bracket, may definitely consider FDs, which will give them around 5 per cent post-tax return. Even high net worth individuals (HNIs) can park a part of their assets in FDs as a diversification strategy.
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Do FDs provide cover against inflation?
Any financial instrument must serve the purpose of growing your money — so, the first thing one must see before putting money in an FD is whether it provides real growth to the investment (net of inflation).
While volatility is seen as a risk by many investing in mutual funds, inflation must be seen as a big risk for FD investments. If adjusted for inflation, fixed deposits actually generate negative returns. Consider this example:
For an investor falling in the highest tax bracket, a 10-year investment of Rs 10 lakh in a bank FD offering 5.4 per cent, will generate a post-tax return of close to Rs 4.4 lakh. This means the investment of Rs 10 lakh would grow to Rs 14.4 lakh after 10 years.
However, if inflation is 5% in the same period — which will be actually around 7% taking into account lifestyle and education inflation — the investor will actually lose money. This is because the investor’s Rs 10 lakh needed to have grown to Rs 16.28 lakh in 10 years just to cover for the 5% inflation. Since the FD grows to only Rs 14.4 lakh, in real terms the investor would be poorer by close to Rs 1.9 lakh.
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What is the outlook for interest rates?
At 4%, the repo rate (the rate at which RBI lends to commercial banks) is the lowest in at least 17 years. While the central bank has already cut the repo rate by 250 basis points since February 2019, in its monetary policy statement in August, the RBI Governor said that the Monetary Policy Committee had decided to hold on policy rates, but it would keep a watch on durable reduction in inflation “to use the available space to support the revival of the economy”.
This essentially means that once the inflation stabilises, RBI will go for a further cut in interest rates to support the economy and prop up demand.
A cut in interest rates would mean that banks would first reduce their borrowing cost before they cut the lending rates. So, fixed deposit investors will see a further reduction in interest rate offerings.
As of now, while SBI is offering a 5.4% interest on a 5-year term deposit, the post-tax returns for those falling in the highest tax bracket (without surcharge) would come to around 3.7%. Going forward, with a further cut in repo rates, banks may reduce their offering further, making it even more unattractive for investors.
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So, should you go for fixed deposits?
For individuals in the middle-income category falling in the highest tax bracket and looking to build a retirement corpus or save for children’s higher education etc., the answer is no. While CPI inflation may be around 6% for now and RBI may have targeted it for around 4%, it is important to realise that lifestyle inflation and education inflation are much higher at around 7-8%. It is therefore important to go for financial instruments that generate above-inflation returns.
Financial planners say that while HNIs can keep some part of their assets in fixed deposits, middle-income individuals should not go for FDs except for keeping some money for liquidity purposes. Individuals whose income is non-taxable, or falls in the low marginal tax rate of 10%, can go for FDs as they will fetch a decent post-tax return.
As for existing FDs, experts say that it is not wise to roll them over beyond what may be required for liquidity, and they should be utilised to repay part of outstanding loans. “Any asset earning a lower interest than the outgo on loan should be utilised to repay and reduce the debt burden,” said Surya Bhatia, founder, Asset Managers, a financial advisory firm.
What should FD investors then look at?
Even for debt investment, investors can look to split their portfolio. An investment corpus that may not be needed for 10-15 years and can be kept for children’s higher education or wedding, can be invested in Public Provident Fund and Sukanya Samriddhi Yojana, which offer 7.1% and 7.6% respectively. Investors can invest up to Rs 1.5 lakh in each of these schemes in a year. In both cases, the interest income is tax-free.
Senior citizens can go for the government’s senior citizen savings scheme that offers 7.4% interest. Investors can put up to Rs 15 lakh in the scheme.
Some other options that fixed deposit investors can consider are Government of India bonds that are currently offering 7.1%; however, this is not fixed, but floating.
Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors, said debt mutual funds too, are a good option for long-term investors, as they offer capital appreciation as well. “Over long periods both inflation and interest rates will trend downwards, and so typically, debt mutual funds will offer capital appreciation to those who can hold for longer periods. It also provides tax arbitrage as compared to fixed deposits. Debt mutual fund investors pay 20% with indexation benefits for investments over three years, and it is more efficient than taxation of fixed deposits for those falling in the 30% marginal tax rate,” Dhawan said. However, investors should only go with debt funds having high-quality AAA-rated papers, he said.
According to Dhawan, those in the highest tax bracket can also go for tax-free bonds, where the current yield is 4.5% — better than FDs.
Bhatia said that while investors can go for short-term debt funds with a quality portfolio, one must look to hold for three years for the best tax benefit.