In 2021, Mr. A invested Rs.6 lakh in a 5 year fixed deposit, earning around 5.5 per cent p.a. After bottoming out, interest rates in general started rising since last year. Now, 1 year FD rates yield around 7 per cent p.a. Mr. A is in a fix. If he breaks the FD, he will have to pay penalty on it. If he does not, he loses out on high returns.
Presently, Mr. B is contemplating to invest in fixed deposits with the prevailing high rates. But he appears to be in a fix too. What if deposit rates rise further? How much money should he park now?
What should investors do?
Fluctuations in interest rates causes such dilemma for investors as to when to lock their corpus and for how much time.
A way to balance the above situation is called Laddering, specifically applicable to fixed income options like fixed deposits, recurring deposits, etc. The idea is to create an investment ladder i.e., divide a lumpsum amount into various blocks, park them in fixed income options and then spread them across various maturities. The idea of a laddering strategy is to optimise the benefit of high interest rates and tackle reinvestment risk. So, for e.g., Mr. B wishes to invests Rs. 20 lakhs in fixed deposits. He can invest Rs.10 lakh in a 1 year deposit, another Rs.5 lakh in a 2 year deposit and the last tranche of Rs.5 lakh in a 3 year deposit.
Laddering thus helps to use the periodic maturity proceeds to reinvest at least a part of the funds at a higher rate. Even in a falling rate scenario, the overall return on the corpus will still be higher than the prevailing rate of return as there would be blocks invested at higher rates earlier.
The above was just a hypothetical example. Practically, the tenure of laddering should take in account short-term liquidity requirements. For e.g., an investor requiring money for short term goals ranging from 1-3 years can spread his/her deposits across different maturities. It also works best for retirees who can invest a big lumpsum amount to avail steady returns by minimising the reinvestment risk and create a reliable income stream every year.
Laddering strategy thus helps to minimise reinvestment risk and ensure liquidity to investors without breaking their deposits.