How laddering, barbell can get better returns for FDs

The appeal of FDs extends to various segments of the population, including risk-averse individuals and senior citizens. These groups often prioritize capital preservation and seek the reassurance of guaranteed returns. The stability of FDs and their ability to protect against market volatility make them an attractive choice for conservative investors.

Yet, not many retail investors are aware of the barbell or laddering strategies that can fetch them better returns on their FDs.

Barbell strategy

The barbell strategy is an approach that involves dividing the FD portfolio into short-term and long-term fixed deposits, while avoiding intermediate-term FDs. This strategy is implemented to take advantage of potential interest rate fluctuations.

Let’s consider an example with a portfolio of ₹20 lakh. The barbell strategy suggests allocating 40% ( ₹8 lakh) to shorter-term FDs with a tenor of 6 months, and 60% ( ₹12 lakh) to longer-term FDs with a tenor of 3-5 years. Assuming an initial interest rate of 7% for the shorter-term FDs and 8% for the longer-term FDs, the returns over a 3-year period can be calculated.

If interest rates continue to rise for the next 6 months, the shorter-term FDs will mature. The reinvested funds can then be placed in longer-term FDs at a higher rate of 9% for a longer duration.

Based on this scenario, the effective returns for the barbell strategy would be approximately ₹5.53 lakh, compared to ₹5.19 lakh for the long-term FDs over the 3-year period.

By following the barbell strategy, an additional interest of ₹34,000 can be earned compared to investing the entire amount in long-term FDs at an 8% rate. This demonstrates the potential benefits of the barbell strategy in capturing higher interest rates and optimizing returns.

Laddering strategy

The laddering strategy is an investment approach that involves spreading out your money across different maturities to maximize returns and reduce risk. By dividing your investment into equal portions with staggered maturity dates, the laddering strategy offers flexibility and helps manage interest rate fluctuations.

Let’s consider an example with a portfolio of ₹20 lakh. The laddering strategy suggests allocating 25% ( ₹5 lakh) each to FDs with different tenors and interest rates.

Assuming an initial interest rate of 7% for the first FD, the funds are reinvested at a higher rate of 9.5% after 6 months for a one-year tenor. The second FD, also starting at 7%, is reinvested at a higher rate of 9.75% after 6 months for a two-year tenor. The third FD, with an initial interest rate of 8.5%, remains unchanged for the entire duration of 2 years. The fourth FD, starting at 8.5%, is reinvested at a higher rate of 10% after 6 months for a three-year tenor.

Based on this scenario, the effective returns for the laddering strategy would be approximately ₹5.87 lakh compared to ₹5.54 lakh for the long-term FD over the 3-year period.

By following the laddering strategy, an additional interest of ₹33,000 can be earned compared to investing the entire amount in a long-term FD at an 8.5% rate. This highlights the potential benefits of the laddering strategy in maximizing returns through the reinvestment of funds at higher rates and distributing investments across various maturities.

Compounding period selection

For FDs with monthly compounding, the interest is added to the principal more frequently, resulting in a higher effective interest rate over time. Assuming a nominal interest rate of 8.5%, the investment with monthly compounding would generate approximately ₹5.78 lakh in returns over a 3-year period. On the other hand, the investment with annual compounding would yield around ₹5.54 lakh in returns over the same duration.

By carefully selecting the compounding period, an additional interest of ₹24,000 can be earned. This highlights the significance of compounding frequency in enhancing investment returns.

Interest income

When it comes to cumulative FDs, banks automatically deduct tax deducted at source (TDS) if the interest earned exceeds ₹50,000 in the case of senior citizen and ₹40,000 for others. This deduction reduces the actual maturity amount received by the investor. However, another loss occurs due to the non-compounding of the TDS amount, as the potential compound interest on that amount is also lost. This further impacts the final maturity value of the FD.

Let’s consider an example with a portfolio of ₹20 lakh. Assuming a nominal interest rate of 8.5%, the investment would generate approximately ₹5.55 lakh in returns over a 3-year period when no TDS is deducted. On the other hand, the investment would yield around ₹5.34 lakh in returns over the same duration when TDS is deducted and not compounded.

In this example, the investor loses an additional interest of ₹21,000 due to the non-compounding of the TDS.

To avoid this loss, investors other than senior citizens can consider diversifying their investments across multiple banks. By spreading their FD investments across different banks, they can prevent unnecessary compounding losses caused by TDS deductions. There is no TDS on interest income up to ₹3 lakh on FDs invested by senior citizens.

Strategies and risks

Both FD laddering and barbell strategies carry certain risks that investors should be aware of. With FD laddering, the fluctuation of interest rates may result in lower overall returns. Additionally, the funds allocated to longer-term FDs may become locked, reducing liquidity and limiting the ability to seize better investment opportunities that may arise.

Similarly, the barbell strategy is not immune to risks, especially when interest rates fall instead of rising as expected. This can lead to lower returns from long-term FDs and reinvesting funds at lower rates upon short-term FD maturity. Both strategies also expose investors to interest rate risk, which can impact returns.

To mitigate these risks, it is crucial for investors to regularly assess their risk tolerance, closely monitor interest rate trends, and diversify their investment portfolio. Regular evaluation and adjustments should be made to align with changing market conditions.