We understand that bank fixed deposits (FDs) are vital for goal-driven investments since they assist in controlling reinvestment risk. Reinvestment risk is the chance that an investor won’t be able to invest back the cash flows from an investment—like interest or coupon payments—at a pace that matches their current rate of return on the investment.
Investors know that all investments carry some risk. Equity investments, for example, carry a substantial market risk. Bank FDs are subject to credit risk, which means that the bank may fail to repay your deposit or fail to pay interest on schedule. Government bonds do not carry credit risk, but they pay interest every half-year, resulting in reinvestment risk. As a result, there is a danger that bond investments will yield less than the needed return in any given year, causing us to fall short of our financial goals.
For example, to attain a 10-year financial objective, consider investing in a 10-year government bond paying 7% per year. This amounts to a 4.9% post-tax return (I have assumed the tax rate to be the highest, which is 30%). To meet your objective at the end of ten years, you must also make 4.9% annually on interest income that you earn from the bond investment (this is to ensure that the overall CAGR returns from the bond investment is 4.9%). The difficulty is that you must discover ways to reinvest your interest income at post-tax return of 4.9% or above. The risk that comes with this is that you will be struggling to discover investing opportunities if interest rates in the economy fall. Furthermore, you must constantly fight the desire to spend the interest income on discretionary things.
Given that most long-term financial goals span more than 5 years, there is a good chance that rates will be reduced throughout this 10-year investing timeframe. Bank Fixed deposits and recurring deposits pay interest upon maturity. We go by the assumption that the possibility of a large bank defaulting on its deposits is relatively low. Also, we have seen in the history of past 100 years that no bank in India has been allowed to default by the government and RBI, and hence the defaulting banks are merged with some other systematically stronger bank. Hence we can be confident here that our deposits do not go bust.
Another way to mitigate bank credit risk is to diversify deposits among many big banks. We may also note that the Deposit Insurance and Credit Guarantee Corporation guarantees your bank deposits, including savings accounts, up to a limit of Rs. 5 lakh per bank.
This demonstrates that bank deposits outperform government bonds in terms of investment potential. That is, investors should be careful about reinvestment risk (government bonds) rather than credit risk (bank deposits).
