by Ronnie Tom Varghese, ACA, CPA, CFA
DEFINING THE PROBLEM:
As the financial year of most Indian banks (31 March 2022) is ending at the time of writing (11 January 2022), it is highly probable that an Indian bank customer is likely to a get a friendly visit from their relationship / wealth manager advertising the latest schemes, be it Fixed Deposits (FDs), Unit Linked Insurance Plans (ULIPs) or any other investment product which in the banks’ view will be beneficial for the customer to achieve their financial objectives.
It is my aim, in this article, to explain to any lay person (any person who does not have a background in finance, accounting, or commerce) the process involved in evaluating an FD investment and to enable them to implement this approach in their personal portfolio.
An investment in an asset is made to achieve any one of the following purposes:
- To earn cash flows: A person may invest in a building with an intent to earn monthly rental income or a person may invest in a dividend paying stock to earn an income which may be in turn use to pay monthly living expenses.
- To generate capital gains: A person may invest in a plot of land with an intent to sell the same at the end of the holding period to generate a corpus of funds, which may be then utilized to invest in other income or capital generating asset or to meet other expenses, such as the purchase of a home, children’s higher education, etc.
- To earn cash flows and generate capital gains.
Given this background, let’s say that you have a sum of money (INR 1,000) to invest and as an investor, you are evaluating whether to invest in an FD or not. In this analysis, the following assumptions have been made:
- FD is held until maturity (20 years, in this example) and there is no redemption in the intervening period.
- The monthly / quarterly / annual interest income cash flows are reinvested in the FD (i.e., the customer does not withdraw any interest income earned until the end of year 20).
- Given the above two assumptions, we can conclude that an investment in this kind of FD is to generate capital gains.
ANALYSIS: BANK’S PERSPECTIVE
The bank representative will make a presentation with the following pitch:
“Dear Sir / Madam, with our FD interest rate return of 10%, for every INR 1,000 invested today, you’ll receive a return of INR 6,727 at the end of Year 20 (i.e., 6.7 times at the time of redemption). So, what are you waiting for? Invest today.”
The mechanics of an FD is based on a concept called “The Time Value of Money”. It states that any sum of money, (INR 1,000) received today is worth more than the same sum of money (INR 1,000) received at the end of Year 1. So, if a person received INR 1,060 at the end of Year 1 for an investment of INR 1,000 at the beginning of Year 1, the investor is compensated at the rate of 6% ((1060/1000)-1). The 6% thus calculated is termed as the interest rate.
For those who may not understand how the above table works, let me explain:
- The columns of 1% – 15% represents the likely range of return (time value) promised by the bank at the time of initial discussion.
- The rows represent the absolute value of the initial investment at the end of each year. For example, if the bank promises a return of 10%, the value of initial investment will be INR 1,100 at the end of Year 1, INR 1,210 at the end of Year 2 and so on and so forth.
- The above table is generated showing a heatmap with the following characteristics:
- Darker the shade of green, it means that those are the cells showing the highest return of all the returns listed in the table.
- Darker the shade of yellow, it means that those are the cells showing the lowest return of all the returns listed in the table.
- Remaining shades represents the transition of the returns based on whether the returns are going from highest to lowest or vice versa.
Based on the review of the above table, we can draw the following conclusions:
- All else equal, higher the interest rate, greater is the total return on investment for the customer.
- All else equal, the longer the period of investment, greater is the total return on investment for the customer.
This is where bank representatives conclude their presentation. However, there are certain nuances that must be understood to evaluate the performance of an FD. Let’s proceed further.
ANALYSIS: INVESTOR’S PERSPECTIVE
In the process of analysing any investment, it is necessary to adjust the returns for the risk inherent in the investment, i.e., an investor must calculate the risk adjusted return of the respective investment.
An investor who parks their funds in an FD, promises the bank not to withdraw their funds until the end of the investment period. The bank takes those funds and charges an additional 4%-5% interest on the funds loaned to borrowers. This interest differential is called the net interest margin (i.e., interest received funds loaned minus interest paid on the FD funds received).
So, what is risk or how would risk be defined? Stated simply, any factor that results in a reduction in the value of an investment or negatively impacts an investment that prevents an investor from realizing their investment objectives stated at the beginning of this article is defined as risk. Risk may be either in the form of financial risk or non-financial risk.
So, the next question we come on to is, what is the risk associated with an FD or stated in other words, what can reduce the value of an FD? The answer lies in the term “Inflation”. Inflation occurs only due to the actions of the Central Government and the Central Bank of any country. When you deposit INR 1,000 in the bank, it can loan that same INR 1,000 to one or more borrowers simultaneously, depending on the reserve requirement specified by the Central Bank, thereby earning multiple times the interest differential of 4%-5%. This is due to the “Fractional Reserve Banking” system that is currently prevalent throughout the world, and it is this that is the main cause for inflation and hyperinflation (extreme inflation).
To understand this in detail, I would suggest the reader to download the book written by Murray Rothbard – “What has the Government done to our money?” (Available for free, easy to understand – 100 pages to read) which outlines the way in which inflation is imposed on the economy (https://mises.org/library/what-has-government-done-our-money). The detailed explanation is beyond the scope of this article.
The following table shows the risk adjusted (i.e., inflation adjusted) returns of an FD investment at the end of Year 20 at different inflation rates (1% – 15%) and at different returns rates (1% – 15%) advertised by banks.
Based on the above table, the following conclusions can be drawn:
- For example, If the FD’s rate of return is 2% and the inflation rate is 15%, an investor would have paid INR 1,000 to receive INR 1,486 in nominal terms at the end of Year 20. However, the investor paid INR 1,000 to receive INR 91 in real terms at the end of Year 20. Nominal returns are meaningless, it is real returns that add value to an investor portfolio.
- If the FD’s rate of return and the inflation rate are equal, the investor has made no real returns. (i.e., the investor paid INR 1,000 as an initial investment to receive INR 1,000 at the end of Year 20).
- The above table is generated showing a heatmap with the following characteristics:
- Darker the shade of green, it means that those are the cells showing the highest risk adjusted return of all the risk adjusted returns listed in the table.
- Darker the shade of red, it means that those are the cells showing the lowest risk adjusted return of all the risk adjusted returns listed in the table.
- Remaining shades (orange, yellow and light green) represents the transition of the risk adjusted returns based on whether the risk adjusted returns are going from highest to lowest or vice versa.
Based on the risk adjusted returns table, I have recalculated the real rates of return at the end of Year 20 at different inflation rates (1% – 15%) and at different returns rates (1% – 15%) which is not advertised by banks.
Based on the above table, we can conclude on the following:
- For example, If the FD’s rate of return is 15% and the inflation rate is 1%, the real rate of return (13.86%) is slightly lower than the difference between the nominal rate of return and the inflation rate (i.e., 15% – 1% = 14%). This is due to the compounding effect of inflation over time which in turn eats into the real rate of return of the FD.
- The differential of 10% rate of return and an inflation rate of 1% provides a similar outcome to the differential of 11% rate of return and an inflation rate of 2% (i.e., the difference between comes out to 9% however, the real rate of return works out to be 8.91% and 8.82% respectively). Therefore, what matters with respect to
FD investment performance is the magnitude of the differential between the interest rate and the inflation rate rather than just the advertised rate.
- Based on the above calculations, it can be concluded that, to get a good rate of return in an investor’s portfolio, the interest rate and inflation differential must be approx., 14% or higher. If the bank representative tells you that the highest interest rate that the bank can offer you is 8%, the inflation rate for the entire investment period must be -6% (i.e., 8%-14% = -6%) or lower. Stated differently, if the inflation rate is 6%, an investor would require a return of at least 20% (i.e., 6% + 14% = 20%) over the entire investment period. Looking at the data in this way can help you figure out whether an FD is a worthwhile investment or not.
- So, why do banks aggressively market their FD products to investors? The reasons are follows:
- Banks are more concerned with their own balance sheets at the end of the year rather than with their customers’ investment objectives.
- Bank representatives are only concerned with meeting their sales targets and getting their bonuses at the end of every financial year.
- It is the responsibility of every investor to evaluate investment options in the context of their financial objectives.
- The purpose in writing this article is to provide an awareness, so that investors will not be pushed into investing in an inferior investment product. Further, through the Betser platform, I aim to assist individuals and businesses in achieving their financial goals. This article is a sample of the quality of work that I’m able to offer. Here’s to seeing you on the other side.