Fixed Deposits and Their ‘Mysterious’ Bond Yields
Earlier this week, I came across a wonderful piece of news in Economic Times that discussed about banks misleading customers on interest paid on fixed deposits (FDs). In the last many months Reserve Bank of India (RBI) has taken series of strict steps in making our financial system more transparent and ensuring that financial institutions/banks follow proper business guidelines.
Some of the measures that were drafted out include banning of banks from charging high interest rates (masqueraded as ‘zero interest loans’) from customers.
Despite such strictness from the Central Bank there are certain banks which are following unethical policies still.
“As per the ET report, the FD pamphlets from such banks carry two columns clearly stating ‘interest rate’ in one and ‘annualized yield’ in other. This annualized yield is calculated on the basis of quarterly compounding for the total period.”
Is offering of ‘annualized yield’ unethical?
The answer is no but promising depositors much higher rates of yield than what these banks usually provide is unscrupulous and must be stopped at the earliest. This only attracts attention of novice depositors who ultimately fall in trap in lure of high yields.
To explain the scenario let’s assume bank ‘A’ offers ~9% yield/annum for its 10 year FD projects that the annualized yield for the same is ~14%. Now on calculating the real compound annual growth rate (CAGR) for a 10 year FD we come out with a number ~9% and not ~14% as projected by these banks.
To find out how these banks arrived at such a high yield number lets enter into some calculations. Let’s assume the amount invested for 10 year FD is Rs 2 lakh.
As the FD is compounded quarterly, 2.5% (1/4 of 9%) of Rs 2 lakh is added at the end of first quarter.
So the value at the end of first quarter goes up to 205,000. Similarly, 2.5% of 205,000 get added at the end of second quarter and this progression continues till the end of 10 years. The return finally comes out to be ~140.00%.
These banks are very smart as they divide this value by 10 years to arrive at the ~14.00% yield that appears to be a very attractive for any depositor.
So, the major problem here as stated by the ET is that these banks project the simple interest (~14%) and not the compound annual growth rate (~9%) and CAGR should be the one that should always be taken into consideration.
For this very reason, even SEBI asks every financial institution in the country to use CAGR for comparison of return rates between two financial products.