Ladder Your FDs To Create A Cushion Against Rate Changes

The Reserve Bank of India (RBI) paused policy rates in the last two monetary policy announcements in April and June 2023, but it’s not clear if it is the end of the interest rate hike cycle. The narrative may have shifted slightly with the brouhaha about rising tomato prices and surging inflation levels in June.

While the US Federal Reserve is expected to raise rates yet again, RBI, too, had issued a caution in its June policy statement. “The pace of monetary tightening has slowed in recent months, but uncertainty remains on its future trajectory as inflation continues to rule above targets across the world,” it said.

A report released by the State Bank of India on July 12, 2023, said: “Though retail inflation remains within the tolerance range of the RBI for the fourth consecutive month (and should remain so for the rest of the fiscal), continued vigil on the evolving inflation outlook is warranted, given the erratic progress of the monsoon and its impact on the Kharif sowing and, subsequently, on pulse inflation.”

In this scenario, those waiting in the wings to lock their money in fixed deposits (FDs) have a tough decision to make—whether to invest into the current rates, which have gone up to nearly 8 per cent for private sector banks in 2023, or to wait a bit longer. The dilemma is about losing out on the opportunity if the interest rates increase further or failing to benefit from the current rates if they dip.

One of the strategies that can come to investors’ rescue in such times is to opt for FD laddering, which helps average out the interest rates over a period of time. Since predictions are hard to make, the FD ladder offers an adequate cushion against the interest rate fluctuations and possibly offer better yield for your invested money.

Cushion Against Rate Changes

The strategy helps to reduce the negative impact of periodic rate change by distributing the funds across multiple FDs with different tenures of maturity.

In a falling interest rate regime, investors usually lock their money for shorter tenures, as it allows them to reinvest the proceeds at higher rates when they rise subsequently. Conversely, in a rising rate scenario, investors book for the longest tenures on offer. However, locking all your money in a single FD may not always be the best option as rate movements are unpredictable.

Says Abhijit Talukdar, a Mumbai-based investment advisor registered with the Securities and Exchange Board of India (Sebi RIA), “Investors generally want to lock in their FD funds at the highest possible deposit rate. However, in practice, it is quite difficult, as predicting the movement of future interest rates is fraught with risk. FD laddering is a technique to de-risk the interest rate movements.”

Making an FD ladder may be beneficial as it balances out returns. Lovaii Navlakhi, managing director and CEO of International Money Matters, says, “If I am following laddering regularly, I am indifferent to changes in interest rate. Some periods will have lower rates and some higher, and when renewing these FDs, I might be in a rate reduction cycle sometime and in a rate increase cycle at other times, so it may all balance out. So, it removes the need to try and get the best rates each time.”

Suppose you have Rs 9 lakh to invest. You may split the corpus into three equal parts of Rs 3 lakh each and invest each tranche into FDs of differing tenures, say, one year to three years. After a year, when the first FD matures, you can reinvest the maturity proceeds at a higher rate if there is a increase in interest, thus ensuring the average returns on your total sum increases. But if the interest rates have fallen over the year, the FD will start earning a lower rate of interest. In this case, the other FDs with longer tenures will continue earning the higher rate, again balancing out the returns. This can help investors optimise their FDs, says Talukdar.

Let’s look at how the returns compare over two interest rate scenarios. Suppose you invested Rs 9 lakh in three equal parts in FDs of one, two and three-year tenures between January 2018 and December 2020 when the interest rates were falling (6.5 per cent, 6.0 per cent, and 4.7 per cent, respectively). In this case, you would have earned a combined interest amount of Rs 1,63,500 after the end of the third year. However, if you had booked the FD with a one-time investment for three years at 6.5 per cent, you would have made Rs 1,75,500. It shows that your returns would have fallen short by Rs 12,000 if you had used the laddering tool.

However, if you had invested in the FD ladder when the interest rates were rising between January 2021 and July 2023 (4.25 per cent, 5.50 per cent and 6.75 per cent, respectively), it would have yielded Rs 1,35,000. Conversely, a one-time investment at 4.25 per cent in a three-year FD would have earned you Rs 1,14,750. Here, you would have gained Rs 20,300 more from an FD ladder (see FD Ladder Vs One-Time FD).

Says Prashant Barwaliya, head of investments at Stratzy, a Mumbai-based fintech company: “Taking into account both the falling and rising interest rate scenarios, an individual who employed FD laddering instead of investing in a long-term FD would have earned an additional Rs 8,250 in interest income over the given time period (2018-2023),”

The FD ladder typically works better in both rising and mixed interest rate regimes. When there are longer-term FDs, the likelihood of mixed interest rate movement is higher, considering that the rates depend on various economic factors.

What Should You Do?

Apart from creating a cushion against interest rate fluctuations, the FD laddering strategy can also help create periodic liquidity.

For instance, if you are a retired individual and need regular cash flow each quarter, you can create a mini ladder with FD tenures of three, six, nine, and 12 months using the same method of FD laddering.

Says Venkatakrishnan Srinivasan, founder of Rockfort Fincap LLP and former senior vice president, debt capital market, ICICI Securities, “FD laddering reduces the interest rate and reinvestment risk besides offering a steady cash flow as the FDs mature at different times.”

However, he adds that a mini FD ladder will, typically, provide lesser returns during the first year of investment.

Depositors can also search for banks offering the best interest rates to sweeten the deal further.

FD tenures, typically, range from seven days to 10 years, and right now, the rates for seniors are around 8 per cent per annum.

Regarding the advantages and disadvantages of FD laddering,  Navlakhi says, “The advantages are that large sums are not available at one time, and the reinvestment risks are diversified. The disadvantages are that one could get caught on the wrong side multiple times, but one must not lose faith in the system.”

Smart Tip: It is advisable to limit the FD amount to Rs 5 lakh in one bank and spread the rest across others. That is because the Deposit Insurance and Credit Guarantee Corporation (DICGC) provides a deposit insurance of up to Rs 5 lakh per bank per depositor. Says Srinivasan: “This rule of the Reserve Bank of India reduces the risk of investors because the threat of a bank default, though implausible, is spread across different banks.” If the funds are deposited in separate banks, they would be separately insured.

sanjeeb@outlookindia.com