Fixed deposits are becoming unsafe with inflation raising its ugly head again. Here are the reasons and alternative investment options.
Now a days a large number of advertisements from banks announcing hikes in their fixed deposit interest rates. An investor or prospective investors would not definitely miss them. They are everywhere â€“ hoardings in railway stations, advertisements on TV, jingles on the radio, etc. If you are impressed with the rate hike it is a misconception. The hikes in bank fixed deposit interest rates are merely an illusion. The truth is Fixed deposits are becoming unsafe.
The hikes in bank fixed deposit interest rates are merely an illusion. The truth is the â€˜realâ€™ return on your bank fixed deposit is miniscule to negative.
When you place your money in a bank deposit, you believe that the interest rate offered by the bank is your income. Wrong. There are two outflows from this interest income. The first one is obvious, and the other, not so obvious.
The obvious one is taxation. Interest income earned on your bank deposit is fully taxable.
The â€˜not-so-obviousâ€™ one is inflation. Inflation eats into all your income â€“ whether it is earned income (salary, business income, etc.) or unearned income (income from your investments). However, in case of a fixed income investment such as a bank deposit, a rise in inflation has an immediate effect.
Presently, banks are offering interest of about 8-8.50 per cent on one-year fixed deposits. Letâ€™s assume that you are earning 8.50 per cent on your one-year fixed deposit. This income is fully taxable. This means that if you fall in the highest tax bracket, i.e. 30 per cent, 2.55 per cent of your interest income will have to be paid as tax (30 per cent of 8.50 per cent). You are now left with 5.95 per cent interest income.
Recently, inflation touched a 2-year high of 6.12 per cent. The main culprit has been a rise in the prices of food items. The supply of essential commodities has been lower than the demand, resulting in rise in inflation. The expectation is that it will be difficult to contain inflation in the near future.
Inflation directly reduces the â€˜realâ€™ return on income through a simple subtraction. This means that assuming an inflation rate of 6 per cent, your bank deposit interest rate of 8.50 per cent, will become 2.50 per cent after reducing inflation.
A combination of taxation and inflation has a profoundly negative effect on your bank deposit interest rate. Letâ€™s understand this dual effect taking our example forward. On your interest rate of 8.50 per cent, after taxation and inflation, your â€˜realâ€™ interest is -0.05 per cent! By placing your money in a bank deposit, you are actually eroding your capital! However, donâ€™t despair. There are better investment alternatives, which are equally safe and help you retain the real value of your capital.
Alternatives to bank deposits:
Mutual funds offer a number of debt schemes, which are good alternatives to bank deposits. These schemes help cope with inflation by either investing a portion of the corpus in equity where potential returns are higher than debt securities thereby helping earn returns that are higher than the inflation rate and/or investing in debt securities with floating interest rate where the interest rate is reset depending on the market rates. In addition, dividend distributed by these schemes is tax-free in your hands. Some of these schemes are enumerated below:
Floating Rate Funds (FRF):
FRF invest in floating rate debt securities such as bonds, floating rate notes, debentures, etc., where the interest paid on the security is reset periodically, depending on changes in market interest rates. Due to this, they help the investor avoid taking the risk of interest rate movements.
Capital Protection Funds (CPF):
CPF invest about 70-75 per cent of the corpus in debt securities, which are rated by rating agencies such as CRISIL, ICRA, etc. The balance 25-30 per cent is invested in equity derivatives, i.e., futures and options. While debt has the required safety, equity derivatives, too, offer safety through hedging with the potential for better returns.
Fixed Maturity Plans (FMP):
FMP are debt funds which are usually close-ended. FMP are comparable to bank fixed deposits, since they invest in securities whose tenures approximately match that of the fundâ€™s tenure. When you invest in an FMP, check with your mutual fund distributor the indicative return on the FMP.
Donâ€™t live with the notion that a clever way to avoid spending time on your investments is to park them in bank deposits at minimum risk and simply watch them grow. Neither will the risk is low nor will your investments grow.