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Why Repo Rate Cuts Make Fixed Deposits Attractive

Why Repo Rate Cuts Make Fixed Deposits Attractive

Why Repo Rate Cuts Make Fixed Deposits Attractive

The Reserve Bank of India (RBI) influences the Indian economy by adjusting the repo rate, the interest rate at which it lends to commercial banks. A recent reduction of 25 basis points to 6.25% signals a shift toward stimulating economic growth. The repo rate cut by the RBI has led to discussions about its impact on various financial instruments, including fixed deposits (FDs). While it might seem counterintuitive, repo rate cuts can make fixed deposits more attractive for certain reasons. This article explores the implications and offers strategies to navigate this evolving landscape.

Understanding Repo Rate Cuts

When the RBI cuts the repo rate, it reduces the cost of borrowing for financial institutions. This typically leads to lower interest rates on loans and deposits. However, for investors who have already locked in higher rates on their FDs, these deposits become even more valuable compared to new investments.

How Will FD Rates Be Affected?

Historically, policy rate cuts by the RBI have led to a reduction in deposit rates across different terms. Typically, financial institutions use the RBI's repo rate as a benchmark when setting their fixed deposit rates. While some institutions may delay immediate transmission of these rate cuts, particularly if experiencing strong credit growth, the general expectation is that new FD rates will trend downwards in the coming months. Current FD holders will continue to earn the higher rates they secured until their deposits mature.

Financial institutions source funds from customer deposits and borrowing from the RBI. When the RBI lowers repo rates, financial institutions’ short-term borrowing costs are reduced. Logically, banks and NBFcs should then cut the interest rates they pay on deposits. This ensures that their margins remain intact.

Now, deposit rates do not fall equally when the repo rate is cut. For instance, if the RBI cuts its rate by 0.50%, financial institutions may reduce deposit rates by, say, 0.25% or 0.30%. The transmission is imperfect. Nevertheless, deposit rates are likely to reduce. As a deposit investor, you enjoy rates much higher than those of other fixed-income instruments.

Factors That Retain FD Attractiveness

Despite the decline in interest rates, FDs remain an attractive investment option for your debt portfolio allocation due to several factors. Here is how:

Predictable Returns

FDs offer predictable returns that are fixed at the time of investment for the entire tenure, unlike volatile market-linked investment options like stocks and bonds. This makes FDs well-suited for conservative and risk-averse investors who want stability of returns. The principal and the promised returns are secure and unaffected by stock market movements.

Reliability

FDs provide complete reliability of the invested capital, as they are unaffected by market fluctuations. The principal remains protected, and only the interest rate is paid out at the specified frequency, irrespective of interest rate movements in the economy. Even if interest rates fall over the tenure, the FD rates remain locked in, and the returns are unaffected. This makes them an ideal choice for capital preservation.

Customisation

One of the biggest advantages of FDs is the high degree of customisation they offer. Investors can choose tenures ranging from 7 days to 10 years, depending on their requirements. Payout frequencies can also be customised to monthly, quarterly, half-yearly, annual, or cumulative as per the investor's cash flow needs. Options for reinvestment and renewals are also available. 

Better Returns Than Savings Accounts

Despite interest rates on FDs coming down in tandem with the RBI's rate cuts, they still offer returns in the 5-9% range per annum today. This is far better than the returns of 3-4% offered on savings accounts. With inflation around 6%, savings account returns are negative in real terms, while FDs manage to provide modest positive real returns.

Temporarily Low Rates

With the economy recovering after the pandemic, interest rates are likely to move up gradually in the future. Therefore, locking slightly higher rates into FDs makes sense. Renewing at higher future rates can then be beneficial versus investing later at much lower rates.

Therefore, while rates have fallen, they are only a temporary low, and the attractiveness of assured and better comparative returns, reliability, liquidity, and flexibility make FDs worthy of inclusion in an investment portfolio.

Conclusion

The RBI's repo rate cuts may have brought down FD rates. However, FDs remain attractive due to their predictable returns, flexibility, lower risk, and better comparative returns. Based on your specific needs, investing a part of your financial portfolio in FDs makes sense. Other debt and equity assets must be blended based on time horizons and risk tolerance. The RBI's current policy stance will likely put downward pressure on FD rates. By implementing the strategies outlined above, fixed-income investors can effectively balance returns and liquidity in this shifting interest rate environment.

FAQs

1. Can I get a loan against my FD?

Yes, many financial institutions provide loans up to a certain percentage of the FD value against FDs to provide liquidity to investors.

2. What happens if I withdraw my FD prematurely?

Financial institutions usually charge a penalty on premature withdrawals. Some institutions may not permit premature closures for FDs below a certain tenure. The interest rate is lowered when an FD is broken before maturity.

3. Which is better – Cumulative or Non-Cumulative FD?

In cumulative FDs, the interest is reinvested and compounded periodically. In non-cumulative FDs, the interest is paid out periodically as per the chosen frequency. Choose your option based on your liquidity needs.

4. For whom are FDs most suitable?

FDs suit conservative investors who prioritise capital preservation and assured returns rather than high growth. Typically, retirees, senior citizens or risk-averse investors prefer FDs.

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