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Friday 29 June, 2007

Inflation at 4.28%, Hits 14-month low

Inflation in India has come down to 4.28%. It is at a 14-month low. You might ask what does this mean and how does it affect me ?. Here are a few implications of the same in the coming months

1. Home loan interest rates will come down by atleast 0.25 to 0.5% in the next few months if this rate of inflation is maintained. Thus those on floating rate home loans can cheer a bit.
2. Effective yields for Fixed Maturity Plans (FMPs) will start coming down and hence if you have some investible surplus then this is a good time to invest in a long term FMP.
3. The long term bond prices will increase in the anticipation of the decrease in interest rates. Thus long term bind funds will give good returns in the near term.
4. Bank stocks will start rallying as the markets will start pricing in increased business prospects for the banks because more people/businessed will start borrowing when the interest rates start to fall (Note that the bank index soared on friday after this news came out in the afternoon). Stocks of car manufacturers and two wheelers will also increase because of anticipation in increases business and buying by individuals.
5. When interest rate falls, the rupee will depreciate (we will see the correlation at some other time) and in which case the prices of gold will increase even if the prices remain stable in dollar terms. The prices of fuel could increase even if the crude prices remain the same in dollar terms. Bottom lines of IT companies could get a boost because of a weakened rupee.

The above are the obvious ones. Sentiment in the stock market increases and could rise to all time highs in the near future.

Wednesday 27 June, 2007

What is Inflation ?

Inflation is an increase in the price of essential basket of goods and services that is required for a common man to survive (something like Roti, Kapda and Makhan) that is representative of a country as a whole. For example the basket of goods in India will include rice, wheat, kerosene, Dhal etc while that of the US could include corn, beef, bread etc as the eating behavior of people are very different.

To understand this better, imagine that India produces only two things namely rice and paper money printed by the Reserve bank of India. In a year when there is a drought and there is a bad crop, rice will become scarce. We therefore will tend to see the price of rice rise, as there will be more money chasing the few kilos of rice that is produced. Conversely, if there's a record crop of rice, we'd expect to see the price of rice fall, as farmers will reduce their prices in order to sell their entire crop. These 2 scenarios depict inflation and deflation respectively at a high level though in the real world inflation and deflation are changes in the average price of all essential goods and services for a country.

So in the recent past when India has been having a booming economy (measured by GDP growth) it leads to more jobs and hence more money with people. However, the output of essential items such as rice, wheat, vegetables etc did not keep pace with the growth. Thus there is more money and less items to buy and hence caused the increase in prices and thus leading to high inflation or increasing inflation.

There are multiple ways to control inflation. In this case, the government can allow import of those essential goods from abroad thus bringing in more supply of the items or release more grains from their PDS (Public distribution system or Ration shops – these are sold to the lower strata of society at a lower price) quota and thus meeting the demand of the consumers.

The government can also control the amount of money in the system. Therefore the Reserve Bank of India increases the interest rates thus trying to prevent business from borrowing money. At every increase of interest rate, there will be one section of the society that will find it difficult to borrow either for business purposes or personal loan or home loan etc. Thus when business is not able to borrow money it internally slows the growth of the companies as it does not have the necessary money to expand their business (True especially for manufacturing companies that need to borrow money for expansion). Similarly when you do not borrow money to buy a bike or car, the demand for car and bikes come down and so on and this affects the car manufacturing company and in turn the car manufacturing company needs lesser workers to produce lesser cars. Some people could lose their jobs. If the company does not scak the employees, their profits will come down and to maintain the profit growth, salary hikes wil be lower, shareholders will have lesser money as decreased profits means that the value of the share comes down etc. This has a rippling effect on the economy till such time that the prices of the essential goods adjust to the new availability of money in the system.

In a nut shell, inflation is caused by a combination of four factors:
* The supply of money goes up.
* The supply of goods goes down.
* Demand for money goes down.
* Demand for other goods goes up.

Monday 25 June, 2007

Investing in Gold

Investment in Gold has always been happening in India for various reasons such as diversification, holding gold as an asset class, Hedge against inflation, Low volatility (not really in the recent past if you look at the price movement of gold) as compared to equities and finally acts as a store of value which can be pledged or sold in the case of dire straits.

Primarily the investment in gold in the past has been in the form of jewellery (worst form of investment in gold if considered from an investment purpose) or gold bars (of 1 gm, 5 gm, 10 gm or 1 tola etc). Some also Trade in Gold futures (will be discussed in future posts).

However, introduction of Gold exchange traded funds allow investors to invest in gold and hold them in a virtual form rather than physical form thus having significant benefits. These are essentially open ended funds that are listed and traded on exchanges like stocks where you can buy and sell them like stocks through stock brokers and hold them in the demat form. These are designed to provide returns that, before expenses (typically between 1% and 2% of the assets under the management will be considered as the management fee) as, closely correspond to the returns provided by physical Gold. Each unit of the mutual fund is approximately equal to the price of 1 gram of Gold.

What are Advantages of Investing in Gold exchange traded funds ?
• Potentially cheaper to have price exposure to gold price as compared to other available avenues such as jeweler, bank
• Quick and convenient dealing through demat account
• No storage & security issues for investors
• Transparent pricing as it is linked to international gold prices and traded in stock exchanges
• Taxation of gains is similar to that of Non equity Mutual Fund
• Listed and traded on stock exchange just like a stock therefore leading to easy buying/selling
• Ideal for Retail investor as minimum lot size to trade is one unit on secondary market.
• NAV of a Unit will track price of approximately 1 Gram of Gold

Schemes such as UTI MUTUAL FUND - UTI GOLD EXCHANGE TRADED FUND (NSE Code - GOLDSHARE) and BENCHMARK MUTUAL FUND - GOLD BENCHMARK EXCHANGE TRADED SCHEME (GNSE Code - OLDBEES) are some of the Gold exchange traded funds that have been launched some time ago.

Schemes such as Kotak Gold ETF are soon going to be launched.

Since the Gold exchanged Mutual Fund is classified as a Mutual Fund, investor need not pay wealth tax. The scheme will have Non equity Mutual Fund Taxation rules applicable as per current Tax laws, where investor has to pay the tax only after redemption. Typically the factors that affect the performance of the fund will be the following

• Closing price of gold in the London Bullion Market Association AM fixing price on that particular day in US$/ounce.
• Rupee to US dollar value. A rising rupee means that gold gets cheaper.
• Crude prices. Increase in crude prices will normally lead to increase in the gold prices.

Typically gold should constitute upto 5% of the portfolio of an individual's assets.

Sunday 24 June, 2007

Comparsion of Bank FD, Debt Mutual Fund and FMP

Now that you have an idea of the Debt fund and FMP, here is a small article on comparing the various instruments and trying to identify which one is the right one for you.

Bank FD
1. Ideal for those in low income tax bracket or no income tax bracket.
2. Ideal for those who want to take no risk at all i.e. who consider that depositing at SBI or ICICI is safer to give than L&T (AAA rated company) through a mutual fund.
3. Ideal for those who are not conversant with the concept of mutual fund and do not want to understand what a debt Mutual fund.
4. Ideal for those who deposit fr a period of 5 year to get the Sec 80C income tax benefit (Indian Income tax rules allow bank deposits for 5 years and above to be treated as an investment for the purpose getting income tax rebate).
5. Ideal for those who do want liquidity but want to be able to get back the principal without any loss.

FMP
1. Ideal for those who think that the interest rates have peaked out for the near future or nearing the peak and want to lock on the yield that one will get for a long period of time. They believe that interest rates will start falling from now on.
2. Ideal for those who do not want liquidity and can wait till the maturity period of the FMP.
3. Ideal for those in the high income tax bracket but want an instrument close to that of a bank deposit.
4. Ideal for investors who are atleast looking at a period of more than 1 year though there is still some benefit for investors investing in FMPs of maturity of less than 1 year but not as much as those investing for more than 1 year.

Debt Mutual
1. Ideal for those who believe in Systematic Investment plan and are looking really long periods of time for their returns so that the good times and bad times get averaged out.
2. Ideal for those who are sure of the time period of their investment
3. Ideal for those who think that the interest rates are peaked out or nearing the peak and want to get high returns by timing the market where they believe that the interest rates will fall fast enough for them to get the capital gains (see my blog on Effect of interest rates on Debt Mutual Fund
4. Ideal for those in an interest rate regime where the interest rates are seen to fall in the future.

So which one should you invest in ??

My take is that one will have to ensure that the portfolio of debt is continuously monitored based on the dynamics of the market and move the funds accordingly.

Right now, I would urge each of you to lock your funds in FMPs of 24-36 months maturity periods.

Here are a few FMPs that are open as of now
1. JM FMF- Sr V- Qtrly 5 - RP (G) from JM Mutual Fund
2. Lotus India FMP-1 month and 3 Series (extended till July 31st)

As the saying goes "Do not put all the eggs in one basket" and have a debt portfolio that best represents you in the current scenario.

Friday 22 June, 2007

Debt Mutual Funds - Part 2

Today we will see what risks exists in debt mutual funds. But before, that it is important for one to understand how debt mutual funds are priced and how the NAV is determined.

Let us assume that there is a company called TCD & Co. Let us say that this is rated by CRISIL and ICRA (rating organizations) as AAA (don't worry about what rating is right now. I will write about sometime in the future to explain its significance). For the moment assume that AAA is very safe and there is a high chance of the money that you give as loan to the company will come back to you and also the interest that the company promises to you will be given. Now at this point of time, if the Government were to borrow money from the public they may give 8% p.a. (Ex NSS, NSC etc), probably TCD & Co may have to pay 8.5% p.a. to attract lenders and also since it is not as safe as the Government of India, let us assume that rate of 8.5% p.a. is the market rate for AAA companies.

So, TCD & Co will issue a bond such that if you lend them (read as invest) Rs. 921.65 today, they will return you Rs. 1000 after one year. This means that the return on investment on Rs. 921.65 for one year is 8.5%.

Thus as we move closer to the maturity date, this value of the bond issued at Rs. 921.65 will slowly start increasing proportionately such that the return will always be 8.5 p.a. for the remaining number of days to maturity.

Now comes the tricky situation when the is a increase in interest rates by the Reserve bank of India (we will see in future why the Reserve bank of India changes the interest rates, impact of that on inflation etc). Let us say that the interest rates increase by 0.5% p.a. after 6 months from the date of issue of the bond by TCD & Co.

After 6 months, if there was no change in interest rates, the bond price would have increased from Rs. 921.65 to approximately Rs. 959.2. However, now we have an increase in interest rates. Thus for the same bond to give a maturity value of Rs. 1000 in 6 months (remaining period of time to maturity), this value of Rs. 959.2 (current price of the bond) has to decrease slightly to Rs. 956.9 so that it gives a rate of 9% p.a. for the remaining 6 months. The reason that the bond price has to decrease is because, if the same TCD & Co were to issue a new bond for 6 months when the rates have increased such that the maturity value is Rs. 1000, then it would have priced it at Rs. 956.9.

Similarly if the interest rates had decreased by 0.5 % p.a. then the price of the bond would have increased accordingly.

The rating of the company (AAA for TCD & Co) also plays a big role in the return that a bond returns.

Thus we see that there is an inverse correlation between the bond prices and the interest rates. Similarly the impact of the increase or decrease in bond prices is bigger for those bonds where the time left for maturity is longer i.e. a bond that has 6 months to mature will change much lower than a bond that has 60 months to mature

There the most important factors that decide the price of a debt security are

Prevailing interest rate scenario
Maturity period

Interest rates are not constant at all. They in turn are dependent on a whole range of macro and micro economic factors. Tracking this is a highly complex and sophisticated exercise.

Also as a thumb rule, take the following

1. In a scenario where the interest rates are increasing, the bond prices will fall and the fall will be bigger if the time left for maturity is longer i.e. longer term debt funds have a bigger impact.
2. In a scenario where the interest rates are decreasing, the bond prices will increase and the rise will be bigger if the time left for maturity is longer i.e. longer term debt funds have a bigger impact.
3. If the debt funds invest a significant proportion of the money in instruments that have a relatively poor rating (say A or A- or BBB+ etc) then there is a default risk of the company that borrowed the money not being able to return the money and hence that money is lost.

Thus when the underlying bond prices increase or decrease, the NAVs get affected and therefore the returns from the debt funds also get affected accordingly.

It is essential for investors to match their investment horizon with that of the debt fund and also understand the mix of portfolio to see what can happen in case of change in interest rate during the period of investment.

Thursday 21 June, 2007

Debt Mutual Funds - Part 1

What is a Debt Mutual Fund ?

A debt mutual fund is a mutual fund that aims to provide regular and steady income to investors by investing in bonds, corporate debentures, government securities and money market instruments such as treasury bills, certificate of deposits, etc. They are ideal for investors who don’t want to take much risk but want steady returns comparable to that of Bank deposits. Many investors invest in debt mutual funds instead of bank deposits because of increased liquidity, lower taxes to be paid etc. However, they are not totally risk free. We will discuss the risks associated in a Debt Mutual Fund especially in an interest regime that is volatile or increasing or decreasing in forthcoming blogs. We will also discuss the benefits of a debt mutual fund and compare it with an FMP and Bank deposit.

Given below ate the different categories of Debt Mutual Funds that address the needs of different investors depending on the time frame of their investment

Liquid Funds or Money Market Funds
These are funds that aim to provide easy liquidity, preservation of capital and modest income. Returns on these schemes do not fluctuate sharply. They are ideal for individual investors that are looking to park their funds for short periods say less than a month and at the same time having better than bank deposit returns.

Short-term debt funds
These schemes invest in debt securities with tenures of less than six months.

Medium-term debt funds
These schemes invest in debt securities with tenures of six months to one year.

Long-term debt funds
These schemes invest in debt securities with tenures of more than one year.

Gilt mutual funds
Gilt funds invest only in government securities. Government securities don’t have credit or default risk and hence they are safer than say a certificate of deposit or money market instruments of a company rated as AAA. However, NAVs of gilt funds can fluctuate with the change in interest rates and we will discuss this in the future blogs. Even Gilt mutual funds are available in the above flavors of Liquid, Short-term, Medium-term and Long-term funds.

Floating rate funds
These mutual funds invest most of their money in instruments with floating interest rate i.e. the interest on these instruments will be linked to a market benchmark and will change if the benchmark increases or decrease. That makes them ideal investment in a rising interest rate scenario.

There are also other schemes such as Balanced funds and Monthly Income Plans where there is a big chunk of debt. They also have a huge chunk of equity and hence these are not pure debt funds and hence am not covering it.

Wednesday 20 June, 2007

Fixed Maturity Plan - FAQ

In my previous blog, I explained as to what is an FMP. Here is a continuation of that. Some of the questions that were unanswered that probably many of you would have wanted are given below

1. How much is required to participate in an FMP ?
A - Like most mutual funds, if you have a minimum of Rs 5000, u can invest in an FMP

2. When do I know that FMPs are launched ?
A - Stay in touch with brokers like Karvy consultants, Bajaj capital, Reliance Money and other distributors and they will be able to let you know when such issues come out.

3. What is the duration of an FMP ?
A - FMPs are available for periods from as lows as 30 days to 30 months. However, you will have to keep your eyes open as to find the one that is most suitable to you.

4. What are the disadvantages of an FMP ?
A - Money is locked till the maturity. If in case you want to withdraw it prior to maturity, one will be given only a window and also there will be some foreclosure fees/penalty (usual 3-4% of the amount) and hence that makes the entire FMP unattractive.

If one is the low income tax bracket, one will have to evaluate the tax benefits of FMP was putting into a Fixed deposit and then see which of them is more tax efficient.

5. Is it safe ?
A - It is safe but no one can guarantee it. Most of the Mutual funds try and invest in various companies that are rated in the AAA category and hence technically they are as safe as a bank. Also, did u know that bank deposits are not guaranteed and have an element of risk ? They are insured only upto Rs 1 lakh. However, given the sensitivity of the issue of a bank going bust, normally the government intervenes and bails it out or asks some other bank to bail it out.

6. Will I get my money only on Maturity ?
A - If you opt for the dividend option, the mutual fund will try and make payment at regular intervals (You will have to read the prospectus or application form to see how often they will declare the dividends). Therefore, this compares well to a Fixed deposit with regular returns and fixed intervals. Also, note that the Dividend from these schemes are tax free as they get taxed by the Mutual fund themselves and is tax free at the hands of the investor.

7. Can I deposit cash ?
A No, I don’t think so. U will need to issue a draft or a cheque and the maturity amount will be made via a cheque or draft. No mutual fund company or broker canvassing the FMP will accept cash.

I have tried to answer the top FAQ. In case you have further questions, please feel free to write to me and I will answer back.

Sunday 17 June, 2007

Why invest in Fixed maturity plans ?

Interest rates in India have been increasing over the last couple of years. This is good news for those breed of investors who invest in bank deposits and fixed income instruments as the interest rates have increased. Today many of the banks offer 9.5% to 10% p.a. returns over the next 3-4 years.

However, should one blindly go ahead and invest in the bank deposits right away ?. Please remember that as per Income Tax rules in India, interest earned from bank deposits are subject to income tax depending on the tax bracket that the individual is in. There are a number of indiviuals who open deposits in their wife's name thinking that these will be tax free. However, even these are expected to be combined into the income of the husband and tax has to be paid tax depending on the tax bracket that the individual is in.

Thus if the individual was in the highest income tax bracket, one would end paying more than 30% of the interest income as income tax thus reducing the effecting return to between 6.5% and 7% p.a.

This is where fixed maturity plans come in and are different from the fixed deposits.

What are fixed maturity plans?
FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is 'guaranteed', but only 'indicated' in the FMP of a mutual fund. The regulator does not allow fund companies to guarantee returns, and hence the 'indicated returns' in FMPs.

FMPs are debt schemes, where the corpus is invested in fixed-income securities for the tenure of the scheme. The tenure can be of different maturities, from one month to three years. These are typically close ended schemes.

The prevalent yield (equivanent rate that the money will fetch as a return for a given tenure from a AAA rated company) minus the expense ratiowill be the indicative return which can be expected from the FMP.

The reason that FMPs are more attractive is because they are more tax efficient. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:
Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.

Long-term capital gains (investment of more than a year) enjoy indexation benefit.

Short-term capital gains are added to the income of the investor and taxed as per one's slab, whereas the interest on a bank deposit is added to the income of the investor and taxed as per one's slab.

Let us take an example of a 30 month FMP which, if launched now, will mature in June 2010. It will pass through three financial years. Thus, it can have a benefit of triple-cost indexation for the purpose of calculating post-tax yield.

Bank Fixed With Indexation Without Indexation
Deposit
Amount of Investment (Rs.) 10000 10000 10000
Post Expenses Yield (p.a)* 8.3% 8.30% 8.30%
Tenor (in months) 30 30 30
Approx Maturity Amt 12,075 12,075 12,075
Gain 2075 2075 2075
Indexed Cost NA 11,406 NIL
Indexed Gain NA 669 NA
Tax Rate 33.66% 22.44% 11.22%
Tax 698 150 232
Post Tax Gain 1377 1925 1843
Approx Post Tax p.a. 5.5% 7.7% 7.3%


Thus it is fairly clear that FMPs are more tax efficient than an equivalent Fixed deposit for a given period of time.