Matters of interest

Matters of interest

Continuously rising interest rates make FDs attractive, but still consider at least two more options.

The banking industry has mounted a blitz, across billboards, newspapers and radio to announce higher interest rates on fixed deposits (FDs). The hoopla is to be expected—banks need to borrow money in order to meet their lending needs. FD rates are edging close to the 10% mark after nearly eight years of single digit returns.

Debt has therefore regained its attractiveness. In a doublewhammy, just as rates have edged up, the equity market has slowed. As we went to press, the RBI raised policy rates on 30 March and that will surely translate into another rate hike across the board. But this uptrend could be temporary. Many financial experts believe that interest rates will plateau and then soften within the next 12 months. So, if you lock into an FD now, the real return (that is, the return minus inflation) could eventually be quite high

In fact, some people are withdrawing funds from long-term savings plans to take advantage of higher FD returns even though most banks are offering these rates only for relatively short tenures and limited periods (see table Deposit Rates). “FDs are more attractive than other small savings products such as NSC, PPF, etc in terms of flexibilty, liquidity and returns. You also have the benefit to choose whatever tenure best suits your needs,” says Subrat Pani, head, retail liability and sales, ICICI Bank.

The nominally high rates are impressive but FDs very rarely beat inflation by much. This only happens if the rate drops during the tenure of the FD. There is also a downside risk for exactly the same reason. Suppose you invest in a one-year FD at 9.5%. Six months later, FD rates fall to 8.5%.

You receive great returns. But if rates rise to 10.5% instead, you lose. Therefore, FDs are not very conducive to wealth creation. If you seek higher returns from debt, explore fixed maturity plans (FMP). These offer greater safety than vanilla FDs.

FMPs are structured like closed-ended mutual funds. But unlike most closed-ended debt funds, they carry no interest rate risk. The base portfolio is locked in and structured to mature at redemption. So, whether rates rise or fall in between, the asset value is protected. The downside is that breaking an FMP prior to maturity incurs a big exit load. So these instruments are illiquid.

“Though one may be tempted by the high upfront figures, the tax environment is different for various investments. Consider any investment only after taking into account the post-tax returns,” advises Edelweiss’ head of wealth management, Anurag Mehrotra.

Investments in FMPs attract long-term and short-term capital gains tax (at 10% and 20% respectively) with indexation benefits. This means you can subtract inflation from your returns before calculating the tax liability.

The pre-tax yields on FMPs and FDs are similar, but if you invest for over 12 months in an FMP, then you attract only 10% as long-term capital gains tax. In contrast, an FD attracts about 34% (inclusive of education cess) if you are in the highest tax-bracket.

Therefore tax-wise it is beneficial to invest in FMPs if you’re in a high-income bracket. “It makes more sense to invest in FMPs over two financial years to take advantage of double indexation. But FMPs are not liquid at all since they have a lock-in period and there is an exit load in case you opt for premature withdrawal,” says financial planner Rohit Sarin.

A third option promises returns that may beat both FDs and FMPs, while offering a fair degree of safety as well. This is an arbitrage fund. Arbitrage funds invest part of their corpus in debt to generate safe returns. They also monitor price differences in the spot and derivatives markets and search for riskfree ways of making a little extra. When they find such price differences, they trade to lock in risk-free returns.

Arbitrage funds enjoy the same tax breaks as equity mutual funds since they are equity-oriented. The only danger in these instruments is that the market does not always provide meaningful arbitrage opportunities. Hence the upside is variable. But the base level return is generated by the debt portfolio.

In the table above, we compared the averaged, annualised pre-tax and post-tax returns of one-year FDs, 13-month FMPs and a basket of arbitrage funds, assuming the highest applicable rate of tax incidence.

The results are interesting. Arbitrage funds underperform in terms of pre-tax returns. But the tax advantage is enough to pull them clearly ahead of FDs at the post-tax level. In a volatile equity market such as now, the arbitrage opportunities are likely to increase while FMP returns will remain static. If volatility remains high, arbitrage funds could also outrun FMPs.