In tune with current times, Claudius in the Shakespearean play, Hamlet, would, have, perhaps, said: “When anxieties come, they come not in single spies, but in battalions!” With uncertainty in employment on one side and volatile financial markets on the other, it is natural that we are overanxious about the world around us.
It is in this backdrop that we address a reader’s question: How safe are bank deposits in these uncertain times? In this article, we show there are no safe investments and that your investment decision involves risk trade-offs.
Default risk
A safe investment is not one that will protect your nominal capital. Rather, it is one that will help you accumulate money at a required rate with zero risk.
Suppose you have to earn 4% compounded annual return to achieve your goal eight years hence, the safest investment would be a cumulative bank deposit with zero default risk. Unfortunately, all banks carry default risk, though low. That means there is a no safe investment! You should, therefore, look for investments with a minimal risk.
You may be aware that the Reserve Bank of India has identified SBI, ICICI Bank and HDFC Bank as domestic systemically important banks. While these banks may reduce your anxiety levels on a default risk, you may not fancy the interest rates they offer.
There is an alternative. In the Budget, the government increased insurance cover that banks offer on deposits (including savings account) from ₹1 lakh to ₹5 lakh.
You can, therefore, spread your deposits across banks such that the maturity amount of your cumulative deposits does not exceed ₹5 lakh in any one bank. Of course, it will be cumbersome to monitor deposits across multiple banks.
Reinvestment risk
What about direct investment in government bonds? True, such investments do not have default risk, but they expose you to high reinvestment risk. To understand this risk, consider a five-year cumulative bank deposit for ₹10,000 at 5.5% interest per annum. In the first year, you earn ₹550 as interest income, which the bank adds to your deposit amount.
In the second year, you will earn 5.5% on ₹10,550. But if the bank were to credit the interest to your savings account, you have to reinvest ₹550 at 5.5 per cent every year. Why?
To earn 5.5% compounded return on your initial investment, you should reinvest your interest income at 5.5% every year. But you could face problems finding investment opportunities every year, especially, if the RBI were to cut interest rates.
So, the risk you run today is that you may be forced to reinvest the yearly interest income at a lower rate in the future. This reinvestment risk is very high for government bonds because you will receive interest every half year.
It all comes down to trade-offs. Suppose, you want to accumulate money for 7 years, you can invest in a recurring (or cumulative) deposit that matures in 7 years. It may be difficult to find a government bond with the same maturity.
You could invest in an open-end bond fund and redeem your units after 7 years. Suffice it to know such funds cannot provide fixed returns because they offer net asset value (NAV)-based returns.
So, if your anxiety levels are high, consider keeping your deposits with the three systematically important banks. If your anxiety levels are not-so-high, then consider other public sector banks in addition to these three systematically important banks. And if you want to get a somewhat higher interest rate, you may have to consider private-sector banks.
Remember this: You cannot avoid any risk. It all comes down to what risks you are comfortable with — zero default risk, high reinvestment risk (government bonds) or low default risk, zero reinvestment risk (recurring and cumulative bank deposits).
(The author offers training programmes for individuals to manage their personal investments)
