Liquidity risk – the difficulty of exit
Bank FDs come with a fixed term to maturity. For example, bank FDs can have maturity as low as few months and go all the way to 7 years. Corporate FDs also have longer tenures stretching from 1 to 5 years. The challenge is that these FDs are not traded in the secondary market. In the case of bank FDs, you have options like loan against FD or breaking the FD by paying a penalty. That is slightly expensive but the option still exists. In case of corporate FDs, there is no exit route available before maturity.
Default risk – when issuers default
There have hardly been instances of commercial banks defaulting on FDs but smaller cooperative banks have been prone to defaults. We saw in the recent case of PMC Bank. In such cases, the investors are vulnerable to default risk. Under the new rules, deposit insurance is available to the tune of Rs5 lakh per account and investors spread their monies across multiple banks for full assurance. However, default is a legitimate risk in many of the small and mid-sized companies.
Inflation risk – taking away real value
To be fair, inflation is risk in any investment. If the FD gives you 8% returns and inflation is 4%, then you get 4% real returns. However, if inflation moves up to 6%, real returns are down to just 2%. Even though the returns on FD are the same, you are realizing less in real value. The difference is that investments like equities and equity funds tend to benefit from higher inflation whereas in the case of FD, the losses are evident.
Fixed deposits also carry Interest rate risk
Bank FD is a commitment for the term of the investment. Once the investment commitment is made you receive fixed return on these FDs till maturity. This creates interest rate risk in two ways. If interest rates go up in the economy, you don’t benefit as you are locked into the FD at current rates. Thus it is an opportunity loss for you. Secondly, there is a piquant situation if rates fall. For example, if you are invested in a 7% FD and if the market rates fall by 1%, then you technically benefit because you are earning more than the market. That is where listed bonds differ. When the rates move lower, bond prices appreciate and you end up with higher returns in a falling interest rate scenario. This is not available in FDs.
The practical Reinvestment risk
This is related to the previous point. If you have a 3 year FD; what happens when the FD matures? You get your money back and let us say you want to extend the FD. You can get a new FD but you will only get the rate that is applicable now. This can put your long term financial plans in jeopardy as you cannot reinvest the money at lucrative rates of return.
Risk of higher taxation
This is a significant risk because at the end of the day, what you take home is the post tax returns. FD returns, be it banks or corporates, are taxed at your peak rate of tax. So, if you are in the 30% tax bracket then your 7% FD will only yield 4.9% post-tax. And if you are in the super income bracket paying over 43% tax then that is the rate of tax that will be applicable to your FD interest too. You need to be conscious of this risk and must always measure your returns in post tax terms only.
Financial plan fitment risk
Last, but not the least, there is the risk of FDs fitting into your overall financial plan. One of the basic conditions is that all investments must fit into your overall financial plan. Normally, investments must be liquid, flexible and tax efficient to easily fit into your financial plan. The FD really does not fit into any of these categories. As a result it is much easier to fit other debt instruments like debt funds or liquid funds into the overall financial plan compared to bank FDs.
FDs are still useful as they are widely accepted as collateral. As an investment product, they have their risks and limitations.