To motivate depositors to deposit more of their money in bank fixed deposits (FDs) in today's rising interest-rate scenario, State Bank of India (SBI) has launched a floating-rate fixed deposit plan under which the rate of interest paid will vary according to the change in the bank's base rate.
Features
Starting September 6, SBI's one-year floating rate deposit will earn an interest rate of 7 per cent (50 basis points below the base rate which is currently 7.50 per cent). A three-year deposit will fetch a return which will be 25 basis points below the base rate, i.e., 7.25 per cent, and a five-year deposit will carry an interest rate of 7.50 per cent (equal to the base rate).
Base rate is the threshold interest rate below which a bank cannot make any commercial, retail or personal loans. It came into effect from July 1, and will be revised every three months after a review. Each bank has the freedom to fix its own base rate.
The objective
According to the first quarter review of monetary policy 2010-11, year-on-year (y-o-y) non-food credit growth accelerated from 17.1 per cent in March 2010 to 22.3 per cent in July 2010. On the other hand, deposit growth has languished at around 14 per cent. With credit growth outpacing deposit growth, banks are confronted with a problem: in future they will simply not be able to meet corporates' fund requirements and will hence not be able to capitalise on the opportunity that this credit upcycle offers. Moreover, with only fixed-rate deposits available, investors prefer to invest only for the short term because they can invest at a higher rate sometime later. This creates an asset-liability mismatch for banks: while the money that they take in is for the short term, the loans that they give out are for the long term.
The floating-rate term deposit is being launched to induce investors to invest a larger portion of their savings in fixed deposits and for a longer term even in a rising interest-rate scenario.
Not the first ever
In its monetary and credit policy of 2002-03, the Reserve Bank of India (RBI) had advised all banks to offer flexible-rate deposits alongside the fixed-rate option. Despite the go-ahead from RBI, most banks have so far been offering fixed-rate deposits only.
Way back in 2001, SBI had launched long-term floating-rate deposits. The rate in this case was pegged to a base rate, which was the rate on term deposits of SBI with a maturity of more than three years. The scheme was applicable only to eight and 10-year deposits. The rate applicable to the former was 0.25 percentage points above the base rate, while in case of the latter it was 0.5 percentage points above the base rate.
Indian Overseas Bank had also launched a similar deposit scheme last year. Here deposits are accepted for a minimum period of three years and up to a maximum of 10 years. The floating rate on deposits with maturity of three to five years has been pegged to the five-year government security rate. The rate on deposits with maturity of over five and up to ten years has been pegged to the rate on the 10-year government security.
Fixed versus floating
If we compare the rates offered by the floating-rate term deposits with those offered by SBI's revised domestic term (fixed) deposit rates, the former appear more attractive.
Deposits parked in a domestic term deposit (SBI) of up to one year pay 6 per cent interest. The interest rate on deposits with maturities up to three years is 7 per cent. Deposits parked up to five years earn 7.25 per cent interest. So the floating-rate deposit of 7 per cent, 7.25 per cent and 7.5 per cent respectively over the one-year, three-year and five-year maturity definitely scores over the plain-vanilla fixed-rate term deposit.
Pros and cons
When the economy is booming and interest rates are expected to move northward, as is the case now, the floating-rate deposit will definitely benefit investors due to the likelihood of the base rate getting revised upward. This is a good product for a rising interest rate scenario. However, it should be used only by the financially literate.
The flip side of this product is that when interest rates head southward, depositors will lose out. The only option left to them will be to withdraw prematurely. If there is a penalty on premature withdrawal, that will lower their returns further. In a falling rate scenario, it will be better to use a long-term debt fund or even a fixed-rate bank FD.
However, one thing should be kept in mind that in FDs the investor's principal is secure; it is only the interest that they earn which will be affected in a falling interest-rate scenario. In case of debt funds, which offer more liquidity compared to FDs, even your principal could get eroded in a rising rate scenario. So while these floating-rate deposits are riskier than fixed-rate deposits, they are less risky than debt funds.
Who should buy?
Yet another issue with the floating-rate deposit is that timing the interest-rate cycle is not at all easy. It is not easy to predict whether and when the interest rate cycle will turn (begin to fall), so that the investor can time his exit from the flexible-rate deposit to perfection. It is also difficult to forecast whether having fallen once, it will fall further or remain steady. Hence only investors who are financially savvy should use this product. It is certainly not a buy-and-forget type of product.
Senior citizens who are dependent upon the income from FDs and are not financially savvy should specifically avoid it.
Alternative approach
Lay investors who find it difficult to time interest rates should rely on traditional FDs but use laddering. Laddering is a strategy that is used to cushion your interest earnings against the vagaries of the interest-rate cycle. Suppose you have Rs 50,000 to invest. Instead of investing the entire corpus of Rs 50,000 in a five-year deposit, you break it up into five equal parts of Rs 10,000 each. Then you invest one block in a one-year deposit, another in a two-year deposit, and so on till you invest the fifth in a five-year deposit. A year down the line, the one-year deposit will mature and it should be reinvested in a five-year deposit. Similarly, when the two-year deposit matures, it should be reinvested in a five-year deposit and so on. The amount received on maturity every year is reinvested to lengthen the ladder. This way one averages out the interest earned over the long term and does not have to worry about timing the rate cycle.
Bottom line
In almost all developed economies, returns on FDs are linked to the market. SBI has launched this product to augment its deposit base. Savvy investors should take advantage of it. But it will be some time before it surpasses the fixed-rate FD in popularity.
