Rising Interest Rates:Will FDs Be More Lucrative Than Debt MFs?

The apex bank of India, RBI, raised the key policy rates recently in its bi-monthly meeting. This is the second time this year that the central bank has raised the policy rates. Earlier, in the month of June, it had raised repo rate by 25 basis points. With these hikes, the repo rate currently stands at 6.5 per cent. These hikes in rates will put an upward shift on the fixed deposit (FD) rates offered by banks. Some of the leading banks have already hiked FD rates. Going ahead, it is likely that the FD rates may go up further. These hikes are being done after several years of decline in average FD rates. In the last few years, interest rates on FDs had dropped substantially. In last five year (since FY14), the rate offered by banks have dropped by anywhere between 22-28%. This has been the case, irrespective of the tenure of FDs. The highest fall in interest rates was seen in FDs of 3-5 year tenures, where on an average, the interest rates fell from 8.925% in FY14 to 6.375% in FY18. Even the savings account, which gives lowest return, has witnessed a fall in the interest rate offered by them. 

Such a continuous fall in the deposit rates had impacted the overall volume of fixed deposits. Bank deposit growth fell to a five-decade low in the fiscal ended March 2018. According to the data released by RBI, the aggregate deposits in the banking system grew by a mere 6.7% in 2017-18, the lowest since fiscal 1963. One of the reasons for such a fall is the higher base of deposits of last year (FY17) due to demonetisation. Besides, the rise of other attractive options such as mutual funds have also adversely impacted the deposit growth rate.

Rise of Mutual Funds 

One of the factors that helped the rise of mutual funds is demonetisation. The debate is still on whether the demonetisation has served its stated purpose. The data released by the RBI shows that 99 per cent of the demonetised currency has found its way back into the banking system. Only a little over Rs 16,000 crore of the Rs 15.44 lakh crore currency has not been returned. Nevertheless, one of the positive and unintentional impact of the demonetisation was the growth of investment in mutual funds. The demonetisation that started in the month of November 2016 led to a huge surge in mutual fund investment. This was reflected in huge increase in number of mutual fund folio accounts of HNIs and institutional investors. On a yearly basis, it increased by 39% and 23%, respectively, in the March 2017 quarter, according to data from the Association of Mutual Funds in India (AMFI).

The growth in mutual fund investment was anyhow seeing traction in the last few years, which gathered steam since demonetisation and has remained unprecedented. It has been able to make a dent into the long standing saving behaviour of Indians. Fixed deposit has remained one of the most preferred routes for retail investors for channelising their savings.

The reason for their popularity is that FDs are being offered not only by banks that are present in every nook and corner of the country, but also by various other financial institutions. Moreover, FDs offer the flexibility of tenures. You can keep a FD for a period ranging from as short as a week to more than ten years. Hence, FDs were considered as the best investment instrument by the investors.

The reason why debt mutual fund is gaining ground as compared to the FDs is because the debt MF clearly offers distinctive advantage over the FDs. However, the debt MF scored the most over the FD on post tax returns and liquidity.

You can withdraw from the debt MF any amount and anytime without attracting any penalty, but you will have to pay short term capital gain tax if withdrawn before three years. The table below clearly shows the return advantage of debt MF. 

Nevertheless, unlike FDs, there is a risk of loss of capital in debt funds. The risk, however, can be mitigated by investing in funds that have a high credit quality portfolio.

Which Is the best option in rising interest rate scenario 

Different debt mutual funds perform differently during a rising interest rate scenario. The graph below shows the performance of the debt funds and movement of repo rate since 2012. It has been observed that during the rising rates, fund with short duration perform better as compared to other types of debt funds. This is reflected in the average performance of these funds when the rates were rising between September 2013 and March 2014.

Therefore, despite the rising bank FD rates, we believe that instead of parking your funds into FDs, you can invest in debt mutual funds, that too in ultra-short-term funds that offer better returns in a rising interest rate scenario.