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Tuesday, November 6, 2012

Interest rates head south, lock your money in long-term FDs

MUMBAI: Reinvestment risk is the buzzword among conservative investors these days. Many financial planners have started advising their clients to get locked into longertenure fixed deposits with maturities of over five years.

This, they feel, will help investors make the most of the prevalent high rate of interest on bank FDs. Also, investors can escape the reinvestment risk because otherwise they will have to settle for lower interest rates when their short-term deposits come up for renewal.

These experts base their advice on the policy review by Reserve Bank of India last week, which they believe unequivocally hints at softening of rates in the medium term.

The RBI slashed the cash reserve ratio ( CRR), or the percentage of deposits banks must keep with the central bankBSE -1.21 %, by a quarter percentage to 4.25%, in its endeavour to keep the liquidity in the banking system at comfortable levels to aid growth.

"It certainly makes sense to invest in a long-term FD of five years now. First of all, the difference between short-term and long-term deposits is barely 50 basis points at the moment, so you will not be making a huge compromise on that front by opting for longer maturities," explains certified financial planner Harshvardhan Roongta of Roongta Securities.

"More importantly, if you invest in a short-term FD, it is likely that at the time of renewal you will be offered a rate that is 200 basis points lower than the current return, as interest rates are only going to drop further in the next 12 to 18 months," he adds. A basis point is 0.01 percentage point.

For instance, many banks today are offering around 9% on one-year FDs and 8.5% on fiveyear FDs. You may decide to park your money in the one-year FD because it offers an extra return of 0.5%. This is despite the fact that you don't need the money in the next five years.

You may face "reinvestment risk" when the FD comes up for renewal next year. If the interest rates go down as predicted, you will have to settle for a lower rate of interest at the time of renewing the FD.

Suppose the prevailing rate at that time is 7.5% for a one-year FD and 7.0% for a fiveyear FD. Then you may lose a chance to earn 1% every year on your five-year FD.

Lure of short-term

Typically, depositors prefer short-term fixed deposits of one to two years as these instruments offer higher rates compared with deposits with tenures of five years and beyond.

As of now, interest rates on one-, two-year FDs are in the range of 8.5-9 .25% per annum. FDs with tenures of over five years, too, are offering comparable returns between 8.25% and 8.75%.

In case of most banks, the difference is not more than 50 basis points, making the case stronger for long-term FDs. Given this narrow gap, you would stand to benefit over the long term by opting for the latter.
Source : The Economic Times, 6 Nov, 2012

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