Why FDs are great & which to choose

Two months back, high net worth investor and portfolio manager Amit Lele walked into his bank with, what seemed like, a strange request. He wanted to transfer a large sum of money into a six-month bank fixed deposit (FD).

With the market rising every day, the bank tried to sell stocks, funds, ULIPs, but savvy investor Lele was using the humble bank FD to park short-term money while the stock market cooled down.

While Lele used the bank FDs for a specific, short to medium term market-cool-down period purpose, others who are lower-risk investors, like the retired, are currently looking at the FD interest rate makeover with renewed interest.

The reason: rates have been rising for the last year and a half, from just 5 per cent in December 2004 to 6.25 per cent on a one-year SBI FD in June 2006, getting the real return (inflation adjusted) to the positive zone. In fact some banks, like ABN Amro are offering an 8 per cent return on a 400-day deposit. How good is the good-old FD as part of your debt strategy and who should use it are some of the things we find out as we ride the FD trail.

Why Fixed Deposits

One reason why FDs are popular even today is the comfort factor. They've been around, we understand them, they are low risk and we know how to get in and out of them. The problem with this trusty old vehicle in the last few years has been the dropping returns, that went as low as 2.75 per cent for one year FD in May 2004.

Adding to the dullness was the blazing stock market that made a paltry half-per-cent real return look poor when people were getting 70-80 per cent on their equity holdings.  

Says, 40-year old Rahul Saxena, a Delhi-based MNC executive, "I found the stock market investment difficult to understand, I found most of my junior colleagues make a killing with their investments in stocks. I took to some random investments that reaped good returns, but I never felt safe with my investment."

Volatile stock markets, along with the rising low-risk returns on the FD, have acted as a wake-up call for the risk averse investor, who is looking favourably at this debt product once again.

Drivers: Though the India story is still on, debt products are being looked at to provide stability to the portfolio. And rising interest rates are making FDs make a come back as one of the products for the debt part of the asset allocation strategy.

Says Abhay Aima, head, wealth management, HDFC Bank, "Ideally every investor should have diverse holdings of assets, including FDs. Deposits are an integral part of an asset allocation."

Agrees Jayant R. Pai, vice-president, Parag Parikh Financial Advisory Services Limited, "What the stock market has done is create a short-term liquidity crunch and banks have taken this opportunity to float lucrative FDs. It is a good time to enter these fixed-return instruments if one wishes to make good use of the schemes on offer."

Another reason for the comeback is the comparatively better yields from an FD as compared to other assets (See below: Debt Yields More). If we define yield as the income that an asset throws off periodically, as rent from real estate, dividend from stocks and interest from a deposit, we see that FDs now make better sense than any of the other assets in the running. Of course, we are not looking at capital appreciation here.

Though safety and liquidity of bank FDs make them popular, financial planners have a different opinion on liquidity. Planners usually prefer money market and debt funds that offer better returns than an FD, are equally liquid and come with a tax advantage. But the sheer dependability and familiarity of a bank FD makes most people unwilling to experiment with the new debt products in the market today.

Deposit your dreams: FDs can in the current scenario play a key role in the debt part of your asset allocation. 58-year old Chennai-based Lalchand C Galada and his wife are staunch supporters of fixed deposits and allocate 20 per cent of their investible surplus into FDs of different types (See below: Fixed Menu) with 20 per cent each going into real estate, gold, equities and back into their business.

"We make minor adjustments in our asset allocation depending on the prevailing interest rates, need for funds into our trading business and our future needs," explains Galada. He is interested in entering new FDs considering the higher rates that are on offer to make best of the situation.

Good Short-Term Option

Though planners may not like FDs too much, but all agree that is perhaps, the best place to park short-term, temporary excess cash. Says B Srinivasan, a Bangalore based, financial planner, "Eventually, inflation adjusted returns from FDs will be nil or negative, hence one must stay away from these for long tenures. But, one must make the best use of these instruments for short-term deposits, while re-aligning the portfolio and asset mix."

However, he feels a lot also depends on an individual and his needs, for instance as one is approaching retirement or is already in retirement, FDs can be a good vehicle to make productive use of cash.

Kishore Ravuri, is a 28-year-old Mumbai-based bachelor, in the communication industry and uses his FDs to make his dreams come true. "Currently I have no financial commitments and I manage my tax-planning well to be left with not great sums to invest, so I use the mix of committed FDs for a year and the rest through my savings bank account that also acts as an FD," he explains.

At the end of each year when it is time to renew his FD, Ravuri makes a decision to continue or splurge on his hobby to travel. "The lump sum amount is enticing enough to use it for my set goals to travel around. Last year I visited Salalah, Oman during the Kharif festival with an archaeologist friend, and found the whole experience very enriching," he says. The trip cost was possible thanks to his FD that matured well in time for him to take a planned holiday, without worrying too much on where to dig in.

Tax on deposits: Again, for those in the highest tax-bracket, FDs may not be of any interest because interest  on bank deposit are taxable at the highest tax slab, but those in the lower tax-brackets have incentives and options that can see FD as part of their asset allocation.

Says Abhishek Leekha, a Yamuna Nagar based financial planner, "You need to be pro-active when committing to an FD. For instance, currently some of the banks are matching the 8 per cent return that government-backed investment options offer. These deposits are good for short-term investments."

Which FD to Choose

But again, with a choice amongst FDs to pick from it is an arduous task to select the most suitable one. "Stay off the co-operative bank FDs. While they may at times offer you a cool 4-5 per cent point over and above what any nationalised bank offers, they can be highly risky," advises Pai.

There are of course other forms of FDs that are available, bank FDs are the most safe amongst available, even though some good manufacturing company FDs may be backed with high credit ratings. "I prefer to mix between company and bank FDs, but, with company FDs I invest only in those that I find are stable and trustworthy," adds Galada.

The key is a planned portfolio. "Financial planning is a tailored activity and is specifically done for an individual and needs constant assessment. So, though FDs may not be the best of options, there are instances when FDs have demonstrated to work very effectively," suggests Srinivasan. He goes on to explain as to how for a retired investor and for senior citizens the additional 0.5 per cent that they get on deposits can work well to support the monthly cash flows.

Soft benefits: It does not end here, FDs can also be used to get soft benefits from your bank. For instance, Saxena uses his deposit to bargain for a rent-free locker in his bank and also has a waiver on his credit card fee. "I see no reason why the bank will not offer me a good housing loan rate for the many years that I have had a fixed deposit with them. These are advantages that I feel I can get at the cost of losing on higher returns from risky products," he says.

People use FDs according to their needs, but the fact is that a bank FD is again looking good, given that the rate of inflation at about 5 per cent, that gives a real return of between 1 to 2 per cent. Not bad for a low risk, liquid product.

But do remember, FDs are not the vehicle for creating wealth, they will keep your moneys safe from capital depreciation in the short to medium term, but over the long term, any change in inflation rates in the interim period could reduce returns. So use them currently for a short duration.

Anytime it looks as if the interest rates have peaked, lock into a medium term horizon. And remember, this is just one of the products in the debt part of your portfolio and not the only one.