Since May 2022, RBI has hiked the repo rates three times to combat inflation. The Repo rate, or the rate at which RBI lends to commercial banks, is up from 4.4% to 6.25%. It has effectively increased the interest rates in the economy.
Thanks to this rise, bank fixed deposit rates are also up, especially on the shorter end. So is it a good time to lock your savings at high rates?
Here are a few points to consider:
While pursuing your goals, the real returns matter and not the absolute. Remember, when we fix our financial target, we base it on the inflation assumption for the period under consideration. If the inflation rates are higher than we assumed, we recalibrate our investment strategy.
RBI is increasing repo rates, as consumer inflation rates are higher than their comfort levels of 4-6% per annum. While there are talks that repo rates have almost peaked, RBI will continue to keep it higher until inflation rates come down.
While the FD rates for 1-2 years are up this year and are about 6%-7% per annum for some banks, does it give you real returns?
Let’s do the math. Assume you invest in a Bank FD that gives 7% per annum. In the case of bank FDs, interest income is taxed annually at the marginal rate (31.2 per cent for the top income bracket).
So, a Bank FD investor in the highest tax bracket will get an effective post-tax annual return of 4.8% from investing in a bank FD. This is lower than the average consumer inflation rate and effectively erodes wealth. Investors should therefore ensure their portfolio earns real return by beating inflation.
In contrast, capital gains for debt funds are taxed at a lower rate of 20 per cent after providing for indexation. This, in turn, makes their post-tax returns superior to that of bank fixed deposits if you have an investment horizon of three years or more.
Also, while inflation in the past has averaged 7% in the Indian economy, inflation rates might be higher for particular goals.
For instance, education or medical inflation has historically been at 10% annual rates. Therefore, investing for these goals requires the backing of asset classes that can beat inflation rates. And that’s where the role of asset allocation is essential.
Achieving a financial goal is more about getting the asset allocation strategy right. It is defined as an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame.
Supposing you can save and invest Rs 1 lakh a month for the next 20 years. And the investment can be increased by 5% every year. In that case, how much should you be able to save?
At 100% debt allocation, about Rs 7 crore
At 50% equity and 50% debt allocation, it will rise to Rs 9.7crore
And at 100% equities, it will be 13.7 crore
So, if you have a financial target of, say, Rs. 10 crores, your asset allocation requires an element of equity to get you there.
Think beyond safe havens
Nothing is guaranteed in the financial world. While some might appear “safe”, none are. For example, while Bank deposit rates are fixed and can be locked up for ten years, banks remain vulnerable to financial mismanagement.
Although it comes with the security of compensation of up to Rs 5 lakh per deposit from Deposit Insurance and Credit Guarantee Corporation (DICGC), FDs don’t have a clean chit.
A combination of investments in low-risk debt fund categories (liquid, ultra-short duration and low-duration funds) suffice for your debt allocations. They carry lower interest rate risk due to investment in debt securities that mature within a year.
While choosing funds, don’t chase returns and focus on safety, for instance, by checking if their investments are in high-safety instruments (Sovereign, AAA, and A1). This, in turn, will allow you to protect your capital and outperform the returns of Bank FDs over a three to five-year period.
Focus on the real and not the absolute returns of investment products. Bank FDs, at best, will safeguard but not generate wealth for meeting your financial goals.
The article was first published in financial express on Jan 25th, 2023, here.