As expected, the Reserve Bank of India (RBI) has cut the repo rate by 0.25% in the annual monetary policy review announced today. The repo rate is the rate at which the RBI lends to commercial banks, which is now pegged at 7.25%. However, the cash reserve ratio (CRR) is kept unchanged.
The rationale behind this rate cut is to step up the deceleration in country’s growth. As RBI mentioned, the growth has to 4.5% in the third quarter of last year, 2012-13 from 9.2% in the fourth quarter of 2010-11.
Hence the underlying assumption is that this rate cut will make loans cheaper thereby triggering the economy’s growth.
But a fall in interest rate on loans implies a fall in deposit rates as well, which is not the best news for investors who are already dealing with volatile equity markets and gold prices. But you still have some scope to mitigate the impact of a likely rate cut on deposits.
Here is how you can save yourself from a likely dip in FD interest rates :-
Factor in the re-investment risk
One has to wait and watch if the banks cut interest rates with immediate effect. However, all macro economic factors and spate of rate cuts in previous RBI policies indicate that the rate is likely to go down in future. Hence, you should consider opting for a longer tenure fixed deposit if you are not clear about the time horizon for the investment. This will help you avert the “reinvestment risk”.
The term re-investment risk describes a situation in which you will have to settle for lower interest rates on FDs when the deposits come up for renewal.
For example, you may opt for a one year fixed deposit since the rates are 25 basis points higher than a fixed deposit of 1-3 years. But when you reinvest the money after 1 year, the deposit rates then may be much lower than the rates offered by banks and companies now.
Hence it certainly makes sense to invest in long-term FDs of a tenure of five years or more.
Split the money among multiple FDs
If breaking a FD in case of an emergency is a concern, you can split the money into 2-3 FDs of different tenures. You can keep a smaller amount in a 1-year FD and higher amounts in 3-5 year FDs. The logic is, in an event of emergency you can break one FD and pay a penalty or lose interest only on that amount. The other amount will be intact. That way you can combat the reinvestment risk and accumulate interest on a long tenure FD.
Stay afloat with Dynamic Bond Funds
Dynamic Bond funds, gives you the flexibility to move your money from short-term into long-term or vice versa based on the fund manager’s outlook on interest rates. Thus these bond funds are well poised to deal with volatility in interest rates. So now with interest rates likely to fall, the fund manager will ideally move the money into longer tenure bond such as corporate bonds or government securities. One of the biggest advantages is that a competent fund manager will be handling your investments
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