Category Archives: Fixed Income

FRDI bill: Please dont Panic!

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Warm Greetings from PenguWIN:

                            Couple of weeks back, one of our clients, who is 3 years away from retirement, reached out to me with the question of safety of bank deposits. Subsequently I got calls from atleast half a dozen clients and yesterday morning, one of our key clients, senior citizen, spooked by FRDI (Financial Resolution and Deposit Insurance Bill), called and wanted to move his major share of bank deposits to Mutual Funds (Liquid Funds). To allay the fear of investors, I thought that I can put together a write-up and will try to keep it simple.

However good the social media tools like Twitter, WhatsApp are, they have their own drawbacks. Both Twitter and WhatsApp are tools to disseminate information; problem is its mostly copied content and forwards to “N” number of people, many a time without even reading the content. A major share of the rumours that the bank deposits of investors can be used for rescuing them (Banks) in an event of financial crisis, can be credited to WhatsApp and Twitter.

The objective of the bill is to set up a new organization, Resolution Corporation that will closely monitor banks/financial institutions and help them resolve, in case of crisis situation. The controversial clause in the bill is the “Bail-In” option where the savings of depositors can be leveraged to rescue the bank. The opposition parties, including Congress have vehemently opposed the bill in the current form and unless all controversial clauses are modified/removed, it will not see the light at the end of the day. Most bank depositors are ignorant of the fact that the current system in place, where a bank gets into a financial crisis, will compensate only to the extent of One Lakh through insurance provided by Deposit Insurance and Credit Guarantee Corporation (DICGC) under RBI. For all these years no one was agitating to revise the insurance amount and why now? The depositors who knew about DICGC too never complained as they firmly believed that RBI and Government will intervene and set things right.

In India, a large portion of the bank deposits are held with public sector banks, which are owned by the Government of India. Hence, usage of depositor’s funds in the banks to resolve issues will have huge ramifications. Unlike other developed countries, our proportion of savings in banks is also high. So, in case the bill is passed in the current form (which is hypothetical) Bank runs (depositors trying to withdraw funds at the same time) will be triggered resulting in colossal impact to our economy. The reason for skepticism in this case is because the rumours are spread with the rider “The current PM is very powerful and is capable of imposing anything like Demonetization”.

About 15 years back there used to be a private bank called Global Trust Bank (GTB) which got into a crisis and RBI and Government rescued it by merging it with Oriental Bank of Commerce, without affecting the interest of the depositors. RBIs scheduled commercial banks ( PSU and Private banks – not cooperative banks) have never defaulted and depositors interests have never been compromised. So, there is absolutely no reason to fear that hard earned money of depositors will be utilized to resolve bank issues. If depositors are not convinced and still sceptical, then there are multiple threats to worry about like a world war getting triggered because of nuclear weapons usage of North Korea or India losing its patience against Pakistan’s support for terrorism and decides to go for a full-fledged military solution (war). I don’t think we are obsessed and worried about wars breaking out and same should be the temperament in the case of FRDI and “Bail-in”

 

<Blog # PenguWIN 1056 – FRDI bill: Please dont Panic!>

Category: Fixed Income, General

For the benefit of Senior Citizens and Good to Know for others

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Dear Friends,
There were constant complaints from Senior Citizens to RBI about the interest rate cuts that resulted in the lowering of Bank FD rates from over 9% to about 7%. Dr. Rajan explicitly mentioned this in one of his speeches and the famous “Dosa Economics” is linked to this (http://penguwin.com/rbi-governor-dr-rajans-dosa-economics/). 
In the Budget 2017, the government announced a scheme which will provide guaranteed returns to Senior Citizens for 10 years and the rate would be a fixed without any changes, thereby giving some solace. 
LIC of India was handed over this initiative and they have executed this (read the attachment). It is referred as single premium pension plan offering 8.3% on a annualized basis and 8% monthly. 
The plan has a 10 year lock-in and the pension will be taxed at the hands of investor. Currently Senior Citizen Savings Scheme(SCSS)  provides a better proposition with Investment of upto 15 lakhs, 5 Years lock-in at a interest rate of 8.4%. While the SCSS interest rates are variable in nature and linked to Government Security Yields (GSec), the probability of this rate going down further is limited.
So, the recommendation would be to exhaust the 15 Lakhs limit in SCSS before investing in this LIC Pension Scheme

<Blog # PenguWIN 1053 – For the benefit of Senior Citizens>

Opportunity in Debt Mutual Funds – II

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How does Debt Funds work and where do they invest?

Debt Fund’s source of returns are interest income and capital appreciation. Capital appreciation is unique to debt funds which is generated through trading of securities.

Investors need to be aware that in Debt funds price is inversely proportional to Interest Rate and Yield. i.e. when interest rates go down, the value or price of the security goes up. Yield in simple terms is the interest paid on the current price of the bond. For a 10% interest rate (coupon) bond with face value of 1000, if the interest rates in the market decreases and price increases to 1100/-, then the yield would be Rs. 100 upon 1100, the current price resulting in a value of 9.1%.

In a decreasing interest rate scenario like the current one where the RBI rates have fallen, bond funds and gilt funds (government bonds) tend to do well. When the reverse happens, then the fund value goes down which means right entry and exits point are required for medium to long term debt funds that rely on capital appreciation

Debt Funds invest in the following instruments depending of their category:

Treasury bills (T-Bills) – Short term instruments issued by RBI on behalf of Government to meet short term requirements of funds

CBLO – This instrument is used for lending and borrowing from overnight to 14 days against collateral of debt securities, similar to call money market

Certificate of deposits (CDs) – this is similar to fixed deposits where the Bank issues certificates to Mutual Funds which they can hold until maturity or trade

Commercial Paper (CPs) – This is similar to company deposits where companies issue these instruments for their short term funding requirements

G-Secs – These are government securities issued by RBI for periods of 1 to 30 years. The 10 year G-Sec is used as a benchmark and the yield on 6.97 %( coupon or interest rate) G-Secs maturing in 2026 is quoting at 6.23

Corporate Bonds and Debentures – Debt instruments issued by corporates for various time periods (Maturity dates). Rating agencies (CRISIL, CARE, ICRA etc.) assess these instruments and provide a rating.

Liquidity and Flexibility

The short term debt instruments like Liquid Funds and Ultra Short Term funds have high liquidity as the securities that they invest have short maturity. Both these products do not have exit load (A few Ultra Short Term do have small exit load). These are excellent alternatives to Savings Bank and short term FDs and in the current scenario, has the potential to deliver returns higher than even long term Bank FDs. The flexibility that these funds offer is such that the redemption proceeds are credited to the investor’s bank A/c’s the next business day. Unlike FDs where the interests paid increases by tenure and when the deposits are prematurely surrendered have a penalty clause, the returns provided by Liquid and Ultra Short funds are almost linear which means if the fund yields say 8% for a year, even if an investor stays in the fund for just one week, they would get similar returns.

Taxation of Debt Funds

Debt funds have a favourable tax treatment over traditional Postal, Bank and Company fixed deposits.

Debt funds invested in growth plan for less than 3 years (Short Term Capital Gains is applicable) are taxed at the slab rate of the investor and the treatment is no different from traditional deposits. However, if the investor chooses dividend option, the fund house pays dividend distribution tax (DDT) at the rate of 28.84% on the corpus assigned for the dividend and the net balance post DDT tax is provided as dividends to the investors, which are tax free. This option works better for people above the 10L tax slab where the tax rate is about 31%. However, the dividend option is not ideal for investors in 10% and 20% tax slabs.

When a debt fund investor chooses the growth option and remains invested for greater than 3 years (Long Term Capital Gains), Indexation benefit (Cost Inflation Index) is applicable to them and only the difference between the indexed cost of investment and the current value is taxed @20%, irrespective of the tax slab of the investor. This is an excellent incentive for investors to consider debt funds rather than traditional products. The following illustration gives a picture of how it works. The CII (Cost Inflation Index) is published every year by Finance Ministry and CBIT (Central Board of Income Tax) and the value for FY16-17 is 1125

Tax Benefit Illustration

Credit Risk

Credit risk refers to the risk of the debt issuer defaulting on interest and/or principal payments. Other than Government securities all other debt products are exposed to Credit Risk. The Rating agencies (CRISIL, CARE, ICRA etc.) assess the Credit profile of these instruments and provide a rating. Typically, the lower rated securities offer higher interest rates and higher rated securities offer comparatively lower interest.

Debt Funds Ready Reckoner

The following table can be considered as a ready reckoner for the various categories of debt Fund, recommended tenure, risk rating (as mandated by SEBI) & average returns for different time frames. Risk Rating is a visual Risk profile of the fund with 5 levels including Low, Moderately Low, Moderate, Moderately High, and High.

Debt funds Ready Reckoner

The returns for 3 months period is absolute and for 1 year and 3 years, its annualized. Investors are requested to start investing in Debt MFs by taking exposure to Liquid and Ultra Short Term funds which have the least risk profile  

Every investment that we make comes with a risk & return profile and so are Debt MFs. The risks need to be understood and allocation to various asset classes needs to be done so as to maximize returns with minimum risk to ones Portfolio

 <Blog # PenguWIN 1045 – Opportunity in Debt Mutual Funds – II>