How To Plan Fixed Income Strategy As Banks Raise FD Rates?

Over the past couple of weeks, several banks led by State Bank of India have raised interest rates on fixed deposits. As a result, the post-tax return prospects for depositors look much brighter at the start of 2023 than they did just a year ago.

Banks have, with a lag, passed on the increase in the Reserve Bank of India’s policy rates since May this year. In a bid to fight inflation, the Indian central bank has raised the repo rate—at which it lends to banks—by a total of 225 basis points to 6.25%. The latest hike, by 35 bps, took place on Dec. 7. A basis point is one hundredth of a percentage point.

At the press conference following the last policy meeting, RBI Governor Shaktikanta Das indicated that the increase in rates over the course of the year had succeeded in bringing inflation lower. And, while he refused to confirm an end to rate hikes, he said that the pace of rate increases would moderate. Economists do not anticipate a sharp increase in the policy rate from this point.  

India’s largest bank, SBI, raised rates on fixed deposits between one and three years—the most popular tenure for the bank—by 50-75 bps with effect from Dec. 13. Despite this sharp increase, banks are yet to completely pass on the RBI’s rate hikes.

Large private sector banks like HDFC Bank Ltd., ICICI Bank Ltd. and Axis Bank Ltd. generally offer 25 bps more than SBI. The smaller banks, like RBL Bank Ltd., IndusInd Bank Ltd. and Yes Bank Ltd. offer an even higher rate in order to attract depositors.

Rates offered to senior citizens on fixed deposits look even more attractive with the latest increases. Banks are currently offering rates of 6.75-8.05% to senior citizens on deposits between one and three years. The rates offered on three-to-five-year deposits range from 6.75% to 7.75%.

Fixed deposits are viewed favourably by investors for their risk-free returns. The primary purpose of these investment products is to offer an interest rate that beats inflation, protecting the purchasing power of the depositor.

In the current financial year, with retail inflation averaging 6.7%, most depositors would have failed to beat inflation. However, the chances of beating inflation in the next financial year—ending in March 2024—are higher, with the central bank estimating the rise in prices at an average of 5.2%.

Investors planning their fixed income investments must, however, pay attention to the post-tax return on fixed deposits. Interest on these products is taxed at the slab rate, meaning that an individual in the highest tax bracket will have to pay 30% tax. And as such, these individuals would be unable to beat inflation on a post-tax basis, at least at the current rate of price increases.

“Investors looking toward fixed deposits are generally looking at smaller tenures and possibly also for regular income,” said Suresh Sadagopan, managing director and principal officer at Ladder7 Wealth Planners. “The tax incidence can be high, particularly for individuals in the highest tax bracket. But based on an individual’s asset allocation strategy, they can choose to have investments in debt mutual funds for the portion of their portfolio they don’t need immediately.”

Debt mutual funds are often pegged as more tax-efficient than fixed deposits. The returns on these funds attract a long-term capital gains tax of 20% after three years. What’s more, investors in these funds enjoy indexation benefits if they earn long-term capital gains.

What this means is that the return net of inflation is taxable at 20%. This dramatically reduces the tax levied. If, however, investments in a debt mutual fund are redeemed before three years are complete, the returns are taxed at the slab rate.

For fixed income investments over three years, a good option to consider is the target maturity fund.

These funds function similarly to fixed maturity plans, in that they invest in debt of the government or companies for a particular period. These bonds are then held till they mature, giving investors the ability to avoid interest rate risk.

Bonds, like equity, are traded on the secondary market. Their prices are affected by changes in the interest rate by the central bank.

The prices and yield on bonds are inversely proportional. In other words, generally, when interest rates go up, bond prices go down. This is because newer bonds are issued at a higher interest rate and the older bonds, as a result, become less attractive. Similarly, when interest rates go down, bond prices rise.

Target maturity funds allow investors to redeem their investments at any point. If they choose to do this, they have to accept the prevailing price of the bonds that are held by the fund. If, however, they choose to hold till maturity, they receive the interest rate indicated by the fund at the onset of the investment. This is also called the yield to maturity.

“We generally advise investors to go for target maturity plans if they don’t have a requirement for funds in two or three years. Target maturity plans are currently investing in AAA-rated corporate bonds, state development loans and government bonds, which offer a high degree of safety,” Sadagopan said.

"The primary point regarding these debt mutual funds is that there is volatility in the net asset value. You have to understand the concept of holding to maturity and getting the yield to maturity,” he said.

Currently, the yield on many target maturity funds is higher than comparable fixed deposit rates.

For example, as on Dec. 19, the Bharat Bond ETF maturing in April 2030 had a yield to maturity of 7.5%. Taking into account indexation benefits and long-term capital gains tax, investors stand to gain more.