CHAPTER 1: FD Investment - Wealth Preservation or Wealth Destruction?

Open economies, access to global markets, ease of cross-currency transactions and liquidity has brought an abundance of global funds to markets. Over the last two decades, precisely after the IT boom, we have seen how the Indian capital market has evolved. In fact, till a few years back Indian equity market was dominated by foreign Money (FPIs) but now Domestic Funds have gained importance and their quantum now often counterbalance the trade volumes of FPIs. Too much liquidity and intention of making quick money has led to extreme volatility and uncertainty in Equity Markets and yes…Volatility and uncertainty are here to stay.

One might think “Why not just simply Stick to BANK FD, Corporate FDs or Debt Mutual Funds and have peace of mind?”  better let’s not even think of Equity. It is volatile and moreover, there are no assured returns. Why should I expose my hard-earned money to this uncertainty? What if I put my entire savings in Bank FDs? Is it possible to stay isolated and buffer ourselves from this uncertainty? Let us understand the following factors before arriving at conclusion. Let us understand the risk associated with FD only model.

1.  Inflation

With simple mathematics, we will calculate the impact of INFLATION on returns from BANK FD. Below mentioned chart reflects the Rate of Interest on Term Deposits provided by HDFC BANK, the largest Private sector bank in India.

For calculation, we will be assuming that a larger portion of savings would be in tenure of 2 to 3 years FDs which promises the interest of 5.15%.

As per the FD calculator of HDFC Bank, the Term Deposit placed on 22^nd June 21 for three years will yield a total interest of Rs.  83,004 and eventually maturity amount will be Rs. 5,83,005 at 5.15% interest rate. Let’s call this 5.15% ‘Nominal Interest Rate’. Now considering average inflation to be 4.5% the ‘Real Interest Rate’ will be 5.15% – 4.50%= 0.65% which is the effective gains we receive from FD. Not to forget this 0.65%p.a. is 'TAXABLE'.

Inflation reduces the purchasing power of money. From the above table, we can conclude that services that are available for Rs. 5 Lacs will require Rs. 5.70 Lacs post 3 years assuming an inflation rate of 4.50%. So, the effective gain is just Rs. 12,422. Meaning ‘Real Rate’ (Inflation-Adjusted Rate) of income is just 0.65% (Pre-Tax) p.a. which is the differential between ‘Interest rate’ offered by Bank and ‘Rate of Inflation’ that is 5.15% - 4.50%. It’s a no-brainer that at this rate it is impossible to ‘Preserve Wealth’ forget about ‘creation of Wealth’. Considering inflation, Real Interest Rate will be negative for deposits above 2crores and for individuals falling in the highest tax bracket.

Below is the chart of Inflation in India. We can observe that average inflation is always above 4% and in fact, RBI has reiterated the target inflation is range is 4%.

2.  Credit Dilution

To quench the thirst for higher interest rates, investors often get attracted towards finding avenues that provide higher interest rates. There are plenty of regional co-operative banks, Group/Chit funds, Credit Societies, low rated Corporate FDs or Sahakari Patpedhis which offer exorbitantly higher rates of interest on Term Deposits. But one should understand that if any entity is offering 11% rate of interest on Deposits, meaning the same entity is lending the funds to borrowers at a much higher rate than 11%.  Consider a case, Bank receives two different loan proposals. The first is from a Salaried person asking for funds for the tenure of 3 years and the second proposal is from Businessperson with diluted credit history and unstable cash flow. Bank will certainly think twice before funding a business proposal over a salaried person’s proposal and even if they agree to go ahead with a business proposal, the Rate of interest on the loan will be exorbitantly high as the probability of losing Interest along with Principal is higher in such cases. This is the typical business model followed by such entities/NBFCs which promises a higher rate of interest on deposits. This is called as ‘Credit Dilution’ or a sugar-coated name would be ‘Credit Opportunity’. The Basis of Credit Dilution Strategy is, ‘Dilute the Quality of Business => Increase the Risk => Make more money by charging higher interest to borrowers. It is as simple as that. But this whole model is against the ideology of having Peace of mind by investing in FD and avoid uncertainty which we have mentioned in the beginning.

 3.  Uncertainty in repayment of Coupon/Principal by Issuer

There have been instances of issuers defaulting or delaying the interest payout. Delay in paying interest or principal amount doesn’t mean there is an immediate Default or bankruptcy. Sometimes there is a delay in repaying promised coupon due to a lack of immediate liquidity at the issuers' end. But there is a very thin line and if the situation is not managed quickly, soon delay can get categorized as default which may result in loss of principal amount as well. Most of the cases which we witnessed in 2019-20 were an outcome of poor Asset Liability Management (ALM). Failing to manage cashflows, results in Asset Liability Mismatch. Hence keeping track of the Coupon or Interest repayment schedule is essential.

There are small saving schemes available that carry sovereign backing for example NSC and Sukany Samriddhi Scheme. The only problem is the lockin Period and eventually immediate liquidity.  The bottom line, one has to be vigilant about one's Debt Portfolio as it carries its own set of risks. In the past investors in PMC BANK, Sahara, DHFL and IL&FS in institutional space have experienced this distress situation. In a nutshell, we can say that the Volatility factor in the Debt portfolio is relatively lower as compared to Equity but there is no escape when it comes to uncertainty. We must agree on the fact that in order to beat inflation and to preserve wealth we need to consider asset classes that offer better Liquidity and better Risk Reward outcomes than banking only on Fixed Deposits. 

*Note - The Content is for informational / study purposes only and should not be used to construe any investment decision.