Fixed deposits may be one of the most popular investment products for risk-averse investors. However, fixed return investments are not entirely risk-free.
“Even a fixed return asset class has risks like interest rate change in the market, default by the issuer, etc. Fixed deposits absorb some amount of the risk in terms of default, and hence offer lower returns than direct bond investments. But there are risks such as default risk, interest rate risk, liquidity risk, credit rating risk, business risk, currency risk, call risk, to name the major ones,” says Vijayananda Prabhu, investment analyst, Geojit Financial Services.
Senior citizens and retirees depend heavily on FDs for a low-risk consistent return on their corpus and to have liquidity. But interest rate fluctuations can impact return on FD investments in the long term. Here is how.
Interest rate risk on FD investment
Suppose you invest a corpus of Rs 10 lakh in an FD for three years at 9 per cent interest per annum for three years and the prevailing interest rate goes up or down in the investment period or on completion of the FD. Assuming the interest rate goes up by 1 per cent after a year, you lose the extra return for the remaining two years. If you break the FD prematurely, you may have to pay a penalty or earn lower interest. If we assume interest falls to 7 per cent on completion of three years, you have to reinvest the corpus at 2 per cent lower return. An investor may also face a liquidity crunch while investing in a long-term FD. In such a scenario, FD laddering could come in useful to mitigate the interest and liquidity risk.
What is Laddering
“Laddering deposits is a way of staggering your investments into multiple FD accounts of varying terms to have liquidity at regular intervals,” explains Adhil Shetty, co-founder and CEO, BankBazaar.
Assuming an investor wants to invest Rs 10 lakh in FDs. He can break that investment into five tranches of Rs 2 lakh each and spread them over five years. He invests the first Rs 2 lakh for a year, the next for two years, and the final tranche for five years. Assuming he is getting 7 per cent interest, he’ll have Rs 2.14 lakh at the end of the first year, which can then be invested in another five-year deposit to create the sixth ladder in the process. This shields the investor against interest rate fluctuation. If interest rates increase in the future, it’s a win-win situation. If they drop, the investor can park his funds in another instrument with higher returns after his deposit matures.
“Investors using FD laddering have liquidity every year, and have the option to create longer income streams. Additionally, they can protect themselves against premature withdrawals,” says Mihir Mehta, founder, Fintuned.
The laddering principle can be applied to all fixed income instruments, whether bank or company FDs, NSCs or KVPs.