Fixed income instruments are often condemned by critics on the grounds that in a rising rate scenario (like the present one), assured returns lead to a notional loss for investors.
While investors in freshly issued instruments rake in returns at higher rates, existing investors continue to languish with lower returns at historical rates. Effectively the instruments' characteristic feature, i.e. "assured returns" turns into a detriment.
The ideal solution to this problem lies in incorporating a certain degree of flexibility in the instruments. What investors need are instruments wherein returns are assured, but the size of returns is flexible.
Periodical resetting of rates in tune with market rates can ensure that investors' interests are protected in a rising rate scenario.
In the fixed deposits segment, HDFC Ltd offers variable rate deposits for investors. The rate of interest is benchmarked against that offered on fixed rate deposits; i.e. interest rates move in tandem with those on fixed rate deposits.
The resetting of interest rates is carried out on first day of the interest period and is applicable for the entire interest period.
For example if a deposit is placed for a 3-year period, with the quarterly interest payment option on December 24, 2004 then the interest rate applicable is the one offered on a similar (3-year and quarterly interest payment) fixed rate deposit.
At the end of 3 months, the interest rate is realigned to the one then being offered on a corresponding fixed rate product. As a result investors have the opportunity to gain from any rise in interest rates.
This is contrary to a fixed rate deposit wherein investors continue to receive returns at historical rates that were applicable when the investments were made
However, variable rate deposits have a downside as well; the same would surface incase the interest rates fall. A downward revision (if any) in rates offered under fixed rate deposits would also be reflected in the returns of variable rate deposits.
Clearly variable rate deposits need not always be a 'win-win situation.'
Investing in tune with your risk-appetite is vital at all times; however risk-averse investors have found the going tough in recent times with assured return schemes offering modest returns. The temptation to rake in higher returns by getting invested in market-linked products has been rather strong.
With variable rate deposits available to investors, they need not make the cardinal mistake of investing in products contrary to their risk-profiles.
For investors of the risk-taking variety, who invest in equities and mutual funds, variable rate deposits make a lot of sense too. Fixed deposits will provide not only the much-needed stability to their portfolios but also enable them to clock better returns with every hike in the rate of interest.
In March 2004, we at Personalfn had recommended that investors should invest in short-tenured fixed deposits with a view to avoid getting locked in at lower rates.
Now 'flexible' styled products offer investors the opportunity to position themselves, whereby they can benefit from the any further hike in interest rates.
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