Why banks are paying you more for your money

It's not only IPO and NFO advertisements that catch your eyes these days. The seemingly out of fashion bank fixed deposits have come back in a big way.

Banks are faced with an increasing demand for loans from retail (you) and corporate borrowers alike. Where do they get the money to loan it to you? Obviously, from the money that you deposit in a bank's various accounts, including the fixed deposit scheme.

But why will you deposit your money in a bank when the stock market is doing so well? Any rational person with some savings would like to put his money in instruments that generate higher returns.

Therefore, if banks have to attract your money, they have to pay you higher returns. This means they need to increase the interest rates on FDs to make them attractive to you.

Here's the bottomline

The long and short of it is that banks are vying for your money to be kept as deposit with them. This mad rush for deposits offers you the opportunity to make higher returns.

So what's on the platter for retail depositors like you?

• What you MUST know about fixed deposits 

To begin with, private banks are offering 9 per cent return on your money for a varying number of years. This means, you can invest in a safe instrument and still get very good returns. These returns are, of course, before tax, but they are nevertheless better than the 5-6 per cent which is what FDs earned not so long ago.

ICICI Bank's website says the bank is offering 9.5 per cent for a 590-day FD. HDFC Bank's website indicates the bank is offering you 9 per cent interest if you keep your money with them for approximately 371 days.

Why FDs are better than stocks

What is a decent return one should expect from the stock market? A very broad range will be 12-18 per cent per annum. There might be very few investors who can claim to generate returns over 18 per cent annually and consistently (We are not talking about actual returns which the Sensex or MFs have given in the last three years, we are talking about how much should a rational investor expect).

Now, if you compare the 12 per cent return from stocks with 9 per cent from FDs, the obvious question will be: Why take such a high risk if the difference is so little? You will get only 3 per cent higher returns by investing your money in the stock market, which involves a higher risk (you could lose your money). Instead, you could invest it in the almost risk-free FD.

How interest rates impact stock price

Secondly, age-old wisdom on Dalal Street says that as interest rates go up, stock prices come down. The logic behind this is that as cost of borrowings for corporates go up, their profit margins come down. When profits come down, investors punish the companies by hammering their prices. Remember, the profits made by a company are directly related to their stock price.

Also, basic economics tells us that as rates go up, people tend to postpone their purchases (or compromise by purchasing a cheaper substitute).

• Want a fixed return? Try these investments 

This means consumers are not as willing to open their wallets as they were earlier (remember, one of the cornerstones of India growth story is the increasing consumerism). As you postpone your decisions, a company's manufactured product -- say refrigerators or television sets for example -- start piling up in their godowns.

This has an impact on the company's inventory levels. When inventories rise, stock analysts do not like it; inventory has a carrying cost which the company has to bear.

Whatever school of thought you belong to, the end conclusion is that the stock market does not look favourably at rising rates.

The final word on FDs

Now comes the clincher: What should you do in such a situation? Take a look at FDs that give high interest rates for a shorter duration.

Why is this combination important?

An FD is like a contract. When you lock your FD for five years at 9 per cent interest, you cannot touch this money for that period. It remains locked with the bank.

• Should you invest in FMPs? 

You feel the pinch only when interest rate moves above 9 per cent for the given period. For example, let's say a bank offers depositors 9.5 per cent interest for a five-year fixed deposit. Imagine this happens after you put your money in an FD that is giving you a 9 per cent return.

This means that when interest rates reach 9.5 per cent, your money is growing at a rate slower than the new rate. To avoid this kind of a problem, you need FDs that give good returns and mature fast. As it matures, you can reinvest the amount at a higher rate.

Readers who are well versed with the bond markets may feel I am underlining a very basic point. For the layman, however, this knowledge is important because FDs have been a traditional mode of investment; their resurgence must be used in the most efficient manner.

The author runs a Nagpur-based finance advisory, Money Bee Investments. He can be reached at moneybee.finplan@gmail.com