Pros and cons of bank deposits

Creating a goal-based portfolio by diversifying the sources of returns requires you to rely heavily on bank deposits for your bond allocation. In this article, we discuss the concerns that many individuals have relating to investing in bank deposits.

Consider first the benefits of bank deposits. You know the maturity value of the deposit when you make the investment. This visibility of cashflows provides stability to your portfolio. Also, bank deposits can compound your investment value, moderating reinvestment risk. This is the risk that if interest were paid every year on the deposit, you may have to reinvest the income at a lower rate should interest rates decline during the life of the investment. But the above benefits have associated costs. Interest income is taxed at your marginal tax rate, substantially reducing post-tax return on the deposit. Also, bank deposits have credit risk- the possibility that a bank may default on the repayment of your deposits at maturity. Most individuals resort to three ways of moderating the perceived credit risk. One, they place their deposits with banks that they are comfortable with. This could be ones with which they have a long-standing banking relationship. Two, they may choose RBI-designated systematically important banks. At present, these are HDFC Bank, ICICI Bank and SBI. And three, they invest in multiple banks, holding deposits of less than five lakh with banks that do not fall under one and two above. This is because deposits up to five lakh are guaranteed by the deposit insurance and credit guarantee corporation in the event a bank defaults. Note that most banks do not require that you have a savings account to create a fixed deposit. Deposits created without a savings account are typically referred to as standalone deposits or digital deposits. Nevertheless, spreading your deposits across multiple banks can make your investment process cumbersome.

It is best to keep your deposits in 3-5 banks. True, all banks expose you to credit risk, but the possibility of defaults are lower compared to, say, investing in a corporate FDs. Note that direct investments in government bonds may not be optimal, for two reasons. One, government bonds expose you to high reinvestment risk. And two, they may be unavailable for the tenure you want at the time you want to make the investment. Finally, if your primary concern is lower post-tax return on bank FDs, think of that as a cost for stable returns.

(The author offers training programmes for individuals to manage their personal investments)