Fixed deposits are the most popular instruments in the fixed-income category. But they are losing their charm because of the low-interest rates offered by banks. To understand why the fixed deposit rates are currently low, we must understand how fixed deposit rateso are determined.
What determines fixed deposit rates?
Demand and supply of credit
The FD interest rates are dependent on the demand and supply of credit in the economy. If consumers borrow less or there is less demand for credit, banks increase their lending rates. Banks’ profit margin depends on the deposit and lending rates. They lend money to borrowers with the deposits they have. If lending rates increase, banks’ profit margin suffers. As a result, banks decrease the interest rates on fixed and other deposits to maintain a favourable profit margin.
The repo rate is the primary tool that the Reserve bank of India (RBI) uses to tackle inflation in the economy. The repo rate is essentially the rate at which banks borrow funds from the RBI. If the repo rate increases, it becomes costlier for banks to borrow from the RBI. Hence, they try to make deposits more attractive by increasing the deposit rates. Similarly, if the repo rate decreases, it becomes cheaper for the banks to borrow from the RBI instead of the public. Hence, fixed deposit rates stay the same or decrease.
Why do bonds provide better interest rates than fixed deposits?
Bonds are fixed-income instruments that offer predictable earnings. They are essential elements of a good investment portfolio because of their low risk and lucrative returns. Investors with a low-risk appetite or dependent on fixed returns are increasingly turning to buy bonds.
Companies or businesses require funds for business operations or expansion. For this, they can choose to borrow from banks or the public. Companies may also borrow to enhance the equity returns of their shareholders. Businesses borrow from banks at the lending rates and raise funds directly from the public via bonds. In return, the companies promise to pay the investors a fixed coupon or interest until maturity and repay the principal invested on maturity.
The gap between the lending rate and deposit rate of banks enables businesses to offer a bond interest rate higher than the fixed deposit rate but lower than the lending rate at which they borrow from the bank.
This is because investors can choose between keeping their money in a bank or a bond. To make their bonds more attractive, companies offer higher interest on their bond than the bank FD rate.
For example, the interest rate offered by banks like SBI on a fixed deposit held for 5 to 10 years is 5.5%. Whereas AAA-rated corporate bonds by companies like ICICI Home and Indiabulls with similar tenures offer an interest rate between 7.4 to 12.
Moreover, since bonds are tradable in the secondary market, there is a possibility of making capital gains as bond prices fluctuate. Bond prices fluctuate due to interest rates and macroeconomic conditions. If the interest rate falls and the price of a bond increases, an investor can make capital gains by selling the bond at this higher selling price.
Fixed deposits and bonds are two of the most popular fixed-income instruments. While they both have similar features like a fixed interest payment and relative safety, they differ markedly across other parameters. For instance, bonds offer higher interest rates than fixed deposits, and while fixed deposits are considered to be safe across the board, the safety of a bond investment is greatly represented by their credit ratings. Hence, investors must educate themselves and choose an asset that best suits their requirements.