Fixed Deposits: Safe investment or risky gamble? What you need to understand | Mint

Traditionally fixed deposits have been one of the most favourite and comfortable investment options for a large segment of Indians. Though other investment avenues like mutual funds and direct equities are gradually gaining importance, close to 15% of household savings still go into fixed deposits.

Investing in fixed deposits could be mostly as it has been a traditional habit for many Indians and may not be a thoughtful decision for most. This article attempts to bring some of the crude realities about fixed deposits which may help investors in decision-making when allocating investments to FDs.

Regulatory protection

Fixed deposits are generally liked by investors mainly for their safety, especially fixed deposits of banks. The Indian banking system is well regulated and stands as a strong destination of trust which draws investors as there is a high level of confidence that the money deposited with the bank can be blindly trusted to remain safe and the interest rate is guaranteed.

Though this is the sanctity of the banking system in the country, regulations laid out by the RBI protect only upto ₹5 lacs of deposits held by a person, regardless of the overall deposit value held in the bank. So, theoretically deposits above 5 lacs held by a person are at risk though the banking ecosystem in India gives the much-needed cushion to believe any amount held in fixed deposits with a bank is safe.

The order of risk

That said, technically FDs held with PSU banks offer the highest order of safety, followed by the private banks which are classified as scheduled commercial banks and then come the other banks. Small finance banks offer more interest than the scheduled commercial banks and investors tend to take advantage of the extra interest by depositing with these small finance banks. 

One needs to rewind history when a moratorium was imposed by the RBI on banks like Global Trust Bank and Yes Bank in 2004 and 2020 respectively due to stressed finances, when depositors were not able to access their deposits for a particular period. Such instances cannot be ruled out for small finance banks and investors ideally should stick to the cream of the banks when safety is the priority.

Non-bank deposits

Apart from banks, corporates also mobilise money in the form of deposits from the public committing a fixed rate of interest. One needs to be careful and very choosy when it comes to these deposits offered by companies. The reputation and vintage of the company along with its credit rating are very important criteria to look at. Investors who cannot analyse the risks of a company on their own and do not have a high appetite for risk should not invest in deposits of companies that do not have a AAA or AA+ rating.

Companies like Bajaj Finance and Mahindra & Mahindra Finance come with a AAA rating and companies like Shriram Finance and Cholamandalam Finance have a AA+ rating. Companies that have a credit rating below this offer higher interest rates which should not tempt investors with low risk appetite. Lower credit rating means the company has a relatively higher probability to default resulting in the probability of depositors not being able to get even the capital back.

When the rating of the company is checked, it’s important to check which rating agency has given the rating. CRISIL, ICRA and CARE are the rating agencies that can be accorded higher credibility with CRISIL being the best. While investing in corporate deposits one needs to check the lock-in period as many of them do not allow pre-closure before 6 months. Even after 6 months, these FDs may have a higher charge on pre-mature exits than banks.

Re-investment risk

Investing in fixed deposits has a high risk called re-investment risk. In the interest rate scenario like the current one, the deposit rates offered are tricky. As the interest rates are expected to be reduced by the RBI in a couple of months, banks offer a lesser interest rate for tenures above 1 year as compared to the 1-year rates. 

If there is a senior citizen completely dependent on the interest income from fixed deposits and has parked in a FD of 1 year for 8.5%, when his FD matures and he goes to reinvest the matured FD amount in an FD later, the interest rate he would get will be lesser than 8.5% creating uncertainty in his interest income. This is called reinvestment risk.

Moreover, in fixed deposits the rate is fixed and is not floating. The rate offered to you when you availed the deposit remains fixed throughout the tenure even if the market interest rate goes up in the interim. One may argue that the rate is fixed even if the market interest rate drops in the interim. But when you take a home loan the interest rate is floating and the rate gets adjusted based on the market rate.

Contrary to FDs, when you invest in avenues like equity mutual funds or direct equities, the return you make at any point in time is based on the prevailing market conditions and you are not deprived of the market opportunity as long as the underlying of your investments are capable of capitalising the market returns. So the re-investment risk associated with FDs needs to be borne in mind when one invests in an FD.

Low to zero real return

Whatever the return offered by an investment product, what a person is really able to enjoy is the real returns left after taxes and inflation. An FD that offers 8% interest, if it’s an ultra HNI will be subject to 39% of it as income tax. So of the 8%, 3.12% goes to income tax and the post-tax yield is only 4.88%. The average inflation in India is about 6%. If the post-tax rate of 4.88% is adjusted for inflation of 6% then the real return is -1.12%. Even when interest rates are at a peak just as the current times, the real returns offered by fixed deposit to an ultra-HNI are negative.

Now, if we were to take the case of a person who pays an average income tax of 20%, the income tax payable on 8% interest is 1.66%(20% plus 4% cess) and the post-tax return is 6.34%. After adjusting for inflation of 6%, the real return will be just 0.34% which only keeps in status-quo and doesn’t really create wealth.

Handicap to compounding

The high tax applicable on fixed deposits makes it a lame product when it comes to wealth creation. In the case of high return generating products like equity mutual funds and equities which offer returns of upwards of 12%, capital gains tax is payable only during the time of realisation of the returns. So until the investment is liquidated, for the years these investments are held, the returns keep on compounding to create huge wealth.

But, in the case of fixed deposits, not only the real returns are low or negative, but tax is payable on the interest accrued and not even on interest realized. This means the low interest made also gets reduced by the taxes every year leaving no room for creating the compounding impact.

These facts about fixed deposits call for one to decode the real risk associated to decide if the risk associated with other products may be better to afford for creating wealth. What appears to be safe on the face of it, takes away what is the key deliverable, returns. Safety which comes at the cost of denying returns may sometimes be sacrificed if there is a better understanding of safety and risk.

After all, the risk associated with equity-oriented investments is relevant only when the period of investment is shorter and when the duration of investment is as long as 7 to 10 years, risk evaporates away and after that risk can just be attributed only to the predictability of the return numbers though it could be as high as low to mid teens or even higher based on market opportunities.

V.Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Ltd.