A better way to manage interest rate risk and provide some liquidity to funds is to 'ladder' one's fixed deposits across different tenures.
Fixed deposits are among the most preferred deposit schemes in India. The secure nature and high rates of interest with flexible tenures ranging from 7 days to 10 years make it highly preferable for both short and long-term investments. However, during emergencies, the liquidity is sometimes a problem. Premature withdrawal from these accounts results in a reduction of returns. Find out how to manage these risks better.
A better way to manage interest rate risk and provide some liquidity to funds is to ‘ladder’ one’s deposits across different tenures. Laddering is an investment strategy in which an investment is made in one or more financial products with different maturity dates. Laddering helps avoid the risk of reinvesting if the interest rate environment is unfavorable and does not restrict to one product. One may invest across bonds and FDs at varying maturities.
Instead of, locking in your funds in a 1-year deposit, you can spread the investment across various tenures, such as 1, 3, or 5-year FDs. When the first FD matures, you can reinvest it for the longest duration and continue till all the FDs get matured. For instance, if you have Rs. 3 lakh and want to make an FD, you can create a three-year ladder strategy with the Rs. 3 lakh, instead of investing your entire available corpus, in a single go. You can break it up into three equal parts of Rs 1 lakh each and invest one block of Rs. 1 lakh each year, till you invest the third in a three-year deposit.
Therefore, you will have three FDs with three different tenures. When each one of the deposits mature, you can reinvest it in another three-year fixed deposit and so on and so forth. Laddering your fixed deposit investments can be done either quarterly, half yearly or every year.
While doing so, ensure that your regular income need is met, and deposits are spread across various maturities and banks. This also ensures liquidity needs are met even over a longer time horizon.
As you reinvest the deposits that mature every year, this brings in the flexibility of liquidity. Hence, in emergencies, if you need the money you can use it. Experts suggest though laddering is well suitable for a retired person, one who needs a regular income can also opt for this.
Speculating, predicting, and timing the marker for direction of interest rates is an impossible task. When interest rates are on the rise, often people break their FDs to reinvest them at the higher rate, by paying a penalty of up to 1 per cent on pre-mature withdrawal. However, if you ladder your FDs, there will always be some money that will mature from time to time, and then you can park funds in different investment avenues if needed.
It is normally known that higher the risk, the higher will be the return. Since laddering mitigates some of the risks, typically the returns are also slightly lower. However, laddering will be ideal for risk-averse people who prefer assured returns.