You must remain invested in bank deposits, unless you are considering the idea of earning higher returns by moving to gilt or liquid funds, says Adhil Shetty, CEO, BankBazaar.com.
Under Raghuram Rajan, the Reserve Bank of India brought the repo rate down from 8 per cent at the start of 2014 to 6.50 per cent when he left office in September 2016.
His successor Urjit Patel brought the repo rate down to 6.25 per cent in this month’s monetary policy review.
This is good news for most people.
Lower interest rates means cheaper borrowing, which could fuel economic growth.
Softening of the repo rate
| Recent Rate Cuts | |
| Month | Repo Rate |
| Jan-15 | 7.75 |
| Mar-15 | 7.50 |
| Jun-15 | 7.25 |
| Sep-15 | 6.75 |
| Apr-16 | 6.50 |
| Oct-16 | 6.25 |
In simple terms, the repo rate is the rate at which RBI lends money to commercial banks.
It is one the tools used by the RBI to curb inflation and the availability of money in the markets.
When inflation shoots up, the RBI will, among other things, tighten the repo rate, thus making borrowing more expensive. Conversely, the RBI will reduce rates to make borrowing cheaper when the inflation rate is under control.
How this impacts fixed and recurring deposits
A repo rate cut has a direct impact on your fixed and recurring deposit rates. Investors looking for fixed income through deposits get negatively impacted.
Banks have the option to borrow from RBI to meet any shortfall in their funds.
The RBI lends them this money at the repo rate, currently at 6.25%. Banks also raise money from customers who have savings accounts and deposits.
So when funds are available to banks at 6.25 per cent, why should they offer a higher rate to investors who hold fixed income instruments with them?
Therefore, banks then would slash deposit rates to bring them in sync with the repo rate. Such a rate cut may not happen in one go and may be done in a calibrated manner in order to not drive away prospective investors.
In January 2015, when the repo rate was 7.75 per cent, the prevailing fixed deposit rates were at 8.25 per cent to 8.75 per cent for deposit of one year or longer.
With the repo rate cut in April this year, deposit rates came down to 7.25 per cent to 7.5 per cent.
It means that with a fall of 1.25 per cent in the repo rate, the deposit rates came down by approximately 1 per cent to 1.25 per cent. With the latest cut, deposit rates can be expected to come down to 7 per cent to 7.25 per cent.
What are some alternatives to FDs?
Fixed deposits and recurring deposits are one of the most favoured and most secure forms of investment.
But with the succession of rate cuts, the post-tax returns on deposits have diminished.
There are only a handful of investment instruments that offer liquidity, safety, and better returns under the current macroeconomic scenario.
Two of these options are liquid mutual fund and gilt funds.
Gilt funds invest in government securities and are considered safe investments. These are subject to interest rate risk and ideal in a falling rate scenario. Liquid funds on the other hand invest in securities that mature in 91 days or less.
Let’s compare the returns from fixed deposits, short term gilt funds, and liquid funds.
| Product | 1-Year Returns | Tax | Return post Tax | Penalty on Premature withdrawal/exit load |
| Fixed Deposit | 7.5% | 30% | 5.25% | 0.5-1% |
| Short Term Gilt Fund* | 9% | 30% | 6.30% | 1% if withdrawn in less than 1 year |
| Liquid Fund* | 9% | 30% | 6.30% | No penalty |
| *Last 3 years approximate annualised return. Data from moneycontrol.com. | ||||
There’s a chance that interest rates will fall further, and therefore gilt funds will continue to perform better in the short to medium term.
However, investors should also explore the opportunity in liquid funds for consistent returns.
If your investment horizon is less than one year, liquid funds will allow excellent liquidity and therefore one can invest in it for a short duration.
What to do if you have a fixed deposit now
If you are already invested in a bank deposit, you would have entered it at a higher interest rate which you will continue to earn regardless of the repo rate cut.
Therefore you must remain invested, unless you are considering the idea of earning higher returns by moving to gilt or liquid funds.
If you’re looking to start a new deposit, this may not be the best time to do it.
With the latest repo rate cut, fixed deposits may offer returns in the range of 7 per cent, therefore bringing your effective returns to around 5 per cent. Since the returns are so poor, you could consider other smarter money moves that assure liquidity, security and higher returns.
Adhil Shetty is CEO of BankBazaar.com
Illustration: Uttam Ghosh/Rediff.com
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