Infrastructure Bonds - A sneak peek

The Budget for the fiscal 2010-11 introduced infrastructure bonds to facilitate financing of long gestation infrastructure projects. The government has notified an investment of up to Rs 20,000 in these bonds to be exempt from income tax over and above the Rs 1 lakh tax exemption under section 80C of the Income Tax Act.  This should result in an additional tax saving of Rs 2,000 to Rs 6,000, depending on the tax slab applicable to each investor.

Structure of Infrastructure Bonds: Amount invested in infrastructure bonds will be used to finance various infrastructure projects in the country. As per the specifications of the central government, infrastructure bonds are to be issued by IFCI, LIC, IDFC and any non-banking infrastructure finance company recognised by the Reserve Bank of India.

While IFCI has recently closed its issue of infrastructure bonds, LIC and IDFC are now set to launch their issues in coming months. The tenure for these bonds is 10 years with a lock-in period of five years. Thus, after a period of 5 years, the issuing company can buy back these bonds from investors.

Alternatively, the investor can choose to trade these bonds in stock exchanges. The issuing company shall offer two rates of interest on these bonds — one is when the investor chooses the buy-back option after the lock-in period and the other is when he chooses to hold on to the investment till maturity period.

Returns and Tax Treatment

Infrastructure bonds will carry an interest rate, which will be determined by the issuing company. The central government, however, has notified that the interest rate so payable shall not exceed the yield on 10-year government bonds. As the current yield on 10-year government bonds is around 8%, investors can expect these infrastructure bonds to offer a rate marginally lower than 8%.

IFCI, for instance, had offered investors an interest rate of 7.85% for bonds with a buyback option after 5 years and 7.95% for bonds without the buyback option and redeemable after 10 years. IDFC, whose bonds have hit the market yesterday (click here), is likely to offer an interest rate ranging from 7.5- 8%.

Investors can opt for either an annual payout of interest or allow the same to be compounded annually and payable only on maturity. Though the principal amount of investment — up to Rs 20,000 — is exempt from tax, the investor shall be liable to pay tax on the amount of interest earned from such an investment. If the investor chooses to trade these bonds in the exchanges after the lock-in period, any gains accrued thereon shall also be subject to long-term capital gains tax.

5-year Tax Saving Bank FD v/s Infrastructure Bonds

As infrastructure bonds have a lock-in period similar to that of a tax saving bank fixed deposit and are expected to offer interest rates similar to the ones being currently offered by banks on their fixed deposits, it is very natural for investors to contemplate as to which one of the two is a better tax-saving avenue.

A 5-year tax saving bank FD is part of the existing 80C basket with a maximum exemption limit of Rs 1 lakh, an investment in infrastructure bonds is an additional exemption of Rs 20,000.

Thus, in case you have already exhausted the exemption limit of Rs 1 lakh through investments in Public Provident Fund (PPF), Employee Provident Fund (EPF), LIC Premium, Repayment of Principal on housing loan etc., you have to opt for infrastructure bonds rather than bank FDs.

As far as the returns from these two instruments are concerned, let us assume an interest rate of 7.85% (as offered by IFCI) for the 5-year infrastructure bond (with buy-back option) and an interest rate of 7.5% on a 5-year tax saving bank FD — as is the prevailing interest rate being offered by most banks.

Thing to note here is that the interest in case of a bank FD is compounded quarterly, but is annual for infrastructure bonds.

Given the above interest rates, an investment of Rs 20,000 shall fetch a pre-tax interest income of Rs 8,999 in the case of the bank FD and Rs 9,183 in the case of infrastructure bonds after a period of 5 years. Thus, it is not the yield on maturity, but the benefit accruing at the time of investment that needs to be considered before making an investment decision.

Risk Element: While there is no risk as far as the underlying asset of these investments is concerned, the embedded risk lies with respect to the institution offering these bonds. It is thus important for investors to carefully scrutinise the credibility of the institution offering these bonds. Moreover, there is still an uncertainity on the future of this mode of investment since with DTC in 2012, there is no mention of these bonds.

There are various articles on internet on this -

1. Economic Times
2. Rediff.com

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Buying ULIPS will Cost Less Now

Insurance Regulatory and Development Authority (IRDA) has announced new set of guidelines for ULIPs. They will now cost lesser but have a longer lock-in period.

IRDA, on Monday, said that insurers will now be allowed to charge up to 4% on annual premium paid on Ulips for the first five years, and thereafter charges will be reduced during the tenure of the policy. For plans of 15 years and above, the charges will be restricted at 2.25% of the yearly premium.

IRDA has also increased the lock-in period for all Ulips from three years to five years now, including the top-up premiums. The decision is expected to make these products more like long-term financial instruments that can provide risk protection. Longer lock-in would also discourage those insurance buyers who often entered Ulips, which are market-linked products, for short term gains. The regulator also increased the insurance cover on such products to 10 times of the first-year premium compared to five times now.

[source]

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Dividend Delusion

An article from Valueresearchonline.com today: One of the most persistent confusions that mutual fund investors have is with the concept of dividends. Many fund investors seem to think that a mutual fund dividend is some sort of a bonanza, an extra bit of money that comes their way because of something special the fund has done. This is not a fringe belief, yet it is so pervasive that giving out dividends has long been a standard method of attracting new investments among fund companies. I have been told by senior sales people of more than one fund company that they even work out thumb rules to figure out how much dividend payout will bring in what amount of fresh investments under which conditions.

This propensity to choose funds based on their dividend payments is a major problem. It is a completely spurious factor with absolutely no merit in it. The only reason why this belief persists can well be that investors do not understand the arithmetic of mutual fund dividends and confuse them with corporate dividends. A mutual fund dividend is basically redemption of your investments in a fund. It (redemption) just happens to be called a dividend. To pay this dividend, the management simply sells off a part of the assets held in the dividend plan of a fund and pays off the proceeds as dividend.

Here's an example of the accounting. Let's say you own a thousand units in a fund with a net asset value (NAV) of Rs 30. Your investment is worth Rs 30,000. The fund declares a dividend of 10 per cent. That's 10 per cent of the Rs 10 face value of each unit. Thus, the dividend is Re 1 per unit. Since you own a thousand units, your total dividend amount comes to Rs 1,000. However, this money will simply be deducted from the residual value of your investment. To pay the dividend, the fund will sell off an appropriate proportion of its assets. When the dividend is paid out, the NAV of the fund will drop by Re 1 to Rs 29. The end result is that when you receive Rs 1000 as dividend, the value of your investment goes down from Rs 30,000 to Rs 29,000. Dividends have no impact on the return you are getting from your investment.

Receiving dividends does have a tax implication. In equity mutual funds, dividends can play a role in tax planning since equity dividend income is tax free. If you invest in a fund and immediately get part of the investment back as dividend then you'll have a loss on your capital. However, one has to hold an investment for at least three months to qualify for a tax set-off with that loss.

The most important thing is the basic non-dividend nature of mutual funds' dividend and that's something that investors must understand. Perhaps the problem is in the nomenclature. Till a few years back, new fund launches were called initial public offerings (IPOs). Then the Securities and Exchange Board of India (SEBI) forbade the use of that term because it led investors to mistakenly believe that new fund launches shared some of the characteristics of new stock offers. Now, new fund offers are called just that - NFOs.

While a similar renaming is unlikely in the case of dividends, knowledgeable investors should stop themselves from choosing funds on the basis of payouts.

[source]

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Skepticism: A tool to investing prowess!

Investing, as they say, is not difficult, but requires a little bit of effort.

Skepticism: By definition means, A doubting or questioning attitude or state of mind. If one maintains this doubting state of mind while making investment decisions as well, one can make some really calculated and good decisions.

Here are a few examples that Dhirender Kumar of Valueresearchonline gives for this:

let's say that a fund distributor wants you to buy a fund on the basis that it gave wonderful returns over the last six months. You could be impressed and just put down your money. Or, you could be sceptical, find out returns over different periods and calculate the effective rate of return, come to the conclusion that other types of funds would be better and invest in that alternative instead.

A perfect example would be when you are being sold a complex product, unit-linked insurance policies (ULIPs) being the perfect example. Typically, you will be told that you will pay charges under different heads like 'premium allocation', 'fund management', 'mortality charges' and so on. If you are not suitably empowered with both scepticism and arithmetic then you would just be impressed by the returns projections shown to you by the agent. On the other hand, if you were empowered with these two qualities, then you would reduce the entire stream of charges and payments and returns to a single rate of return. Then you would see how this rate of return would be impacted if the reality of market returns would prove to be a little less rosy than the insurance company's projections. Then, you would calculate whether buying the ULIP would be better, or buyin g a term insurance and investing somewhere else.

However, if you don't doubt others advice, you may end up buying things that are not as good for your future as they are for other's. So, be a skeptic, doubt/question whatever is told to you about any investment vehicle and then make your decision based on your own research.

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Understanding SIP

You Earn Regularly…

You Spend Regularly…

Do You Invest Regularly?

Systematic Investment Plan (SIP), is a is a simple and time honored investment strategy for accumulation of wealth in a disciplined manner over long term period.

SIP or systematic investment planning is method through which you can invest in mutual funds through small and periodic installments. Infact you can invest as low as Rs. 1000/- on a monthly basis. Moreover you can also select the tenure of the instalments.

The systematic style of investing is actively promoted by practically everyone who gives advice about fund investing. Whether these are fund companies, advisors, or the media, an SIP is supposed to be the holy grail of mutual fund investing. Unfortunately, there seem to be a growing number of investors who have cottoned-on to the notion that SIP investing is some sort of magic. There are two widespread misconceptions about SIPs: some investors believe that an investment through the SIP route cannot have poorer returns than a lump-sum investment made at the same time that the SIP was started. The other, more extreme point-of-view is that you can’t make a loss in an SIP, no matter what. Both are equally wrong.

The basic idea behind an SIP is that while the general direction of an investment (a fund or even a stock) is upwards, it is not possible to reliably predict the actual fluctuations that it may undergo as part of its general trend. Instead of trying to time one’s investments, one should regularly invest a constant amount. As time goes by and the investment’s net asset value (NAV), or market price, fluctuates, it will automatically ensure that when the NAV was low, you ended up purchasing a larger number of shares or units. Eventually, when you want to redeem your investment, all the units are worth the same price. However, because your SIP meant that you bought a larger number of units whenever the price was low, your returns are higher than they would otherwise have been.

There is another reason why SIPs make sense. They are a great way to override the normal psychological instinct to stop investing when prices fall. In my experience, this is the real value of SIPs. The normal tendency is to invest more when prices are high and to stop investing when prices fall. This is the opposite of what is the most profitable way of investing. SIPs force you to follow the opposite approach, much to your eventual benefit.

[source]

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What is Face value and book value?

Past few posts we have been metioning this word (face value) a lot. So, what is face value? How is it different from the market value of the share? Why do we need this? How does it matter to me as a share holder? We will try to answer some of these in this post.

Face Value

By the definition of it, Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question (as with circulation coins) it can sometimes be largely symbolic, as is often the case with bullion coins. For example, a one troy ounce (31 g) American Gold Eagle bullion coin was worth and used to sell for about $670 USD at current market prices (as of July 17, 2006) and yet had a face value of only $50 USD.

For a share this is decided by the company issuing it, at the time of initial offering .It is mentioned on the face of share, Bond certificate or other financial instrument. Face value has nothing to do with market value of the share. Market value of shares changes depending on several conditions. Face value changes only when splitting takes place.

Let me use an example. Suppose,  you want to start a Company with the Capital of Rs. 1,00,000. Now, to arrange this money you take help from  friends and relatives. In exchange, you issue shares of your company, it can be 100 shares, each of the Face Value of Rs. 1,000; or 1,000 shares of Rs. 100 each any such value.

Now let us bring in other value, the Book Value.

Book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities

Suppose your company grows 10 times in a given period of time, and it is worth Rs. 10,00,000. The price of the share of your Company will also grow 10 times, i.e. the book value of a share of the face value of Rs. 10 will become Rs. 100. In case of a loss on the other hand, if your company is  worth only Rs. 10,000, the book value of the share of face value Rs. 10 will become Re.1 only. The Shares are first valued on their Book Value and then by the future prospects or risks involved. If the future prospects are good, I will buy a share (issued by you for Rs. 10 FV, now at Rs. 100 BV) for Rs. 120 or Rs 280 (market value). This will depend on the Market, at what price the holder of the share in your company, is willing to sell. And, suppose, your Company is making losses, I will not buy the share of FV Rs. 10, now available at Re. 1, even if the holder agrees to sell at Re. 0.40. And that is the reason why the shares of different companies sell at different prices.

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Did your company just Split Shares?

Thought to do a separate post on share splits after getting a lot of comments/questions on this. see comments at http://taxingsalaried.blogspot.com/2009/10/what-is-bonus-share.html.So here is a humble try to explain what a share split is.




What is a share split


When a company splits its shares, it agrees to issue additional shares to the existing share holders, but it doesn't intend to issue new shares like in a Follow-on Public Offer. The shares would come from the existing shares only and hence the face-value of the existing shares would be reduced. For example, if a stock has a face value of Rs 10, a two-for-one stock split will mean that there will be twice the number of shares as before with a face value of Rs 5 each for the new share. So if an investor owns 100 shares, he will have 200 shares after the split. In case of a five-for-one split, there will be five times the number of shares and the investor will own 500 shares for every 100 shares.


Fair enough, but how is this different from a bonus share


As discussed in the other post, in case of a bonus share, the current market price of the share decreases and the face value remains constant, where as in case of share split, both change. 


These 2 are inherently different in terms of accounting. A bonus reduces a company's reserves, converts it into equity capital and then issues additional shares from it. In absolute rupee terms, the equity capital (number of share multiplied by the face value) rises after a bonus. After a 1:1 bonus, the equity capital will double.
In a split, the absolute rupee capital is maintained at the same level and the reserves remain as before.


Merits of such an action

• To make the share price affordable for more people to buy them in open market.
• Increase in liquidity. It is now more readily available in the market to be traded.

What does it change


Practically nothing! A share split or a bonus changes nothing on the fundamentals of the company. It is much like cutting a 12 inches pizza into 8 pieces instead of 4. But investors love stock splits and bonuses. Empirical studies in the US do suggest that stock splits improve prices in most cases as investor sentiment improves. Bonus issues in India have also provided returns to investors.


Analysts do feel that both bonus and stock split indicate the management's conviction to sustain a higher profit growth to service the higher number of shares.

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Recession Over???

The last one and a half year has been like hell for every one. The economy of the entire world slowed down drastically forcing organizations to cut jobs and sending the economy in a downward spiral.


Some of the most common questions these days are: Is recession coming to and end? Is economy showing an improvement? Has the employment rate recovered? Recession is generally described as "a period of economic decline". Lets find out some signs which show that recession is coming to an end.

• A survey of 44 professional forecasters released by the National Association for Business Economics USA, also known as the NABE, found that 80 percent of the respondents believed the economy was growing again after four straight quarters of declines. 
• The latest government data on Monday showed the economy growing by 6.1% year-on-year during the first quarter (April-June) of the fiscal the fastest for any quarter since the global financial crisis began almost a year ago making officials expect 6.5% growth this year making India the second-fastest growing major economy after China, which notched almost an 8% growth rate. More importantly, it's an improvement over the 5.8% notched up by India in the previous quarter and 5.3% recorded in the quarter before that. see this video: 

• FIIs are coming back!

Let's hope these signs result in an end to the recession.

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Dividend Explained...

To carry on what we started with "what is a bonus share?", let's discuss dividends today.

Definition of Dividend

That part of the earnings of a corporation that is distributed to its shareholders; usually paid quarterly. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

What's in it for me (WIIFM)?

When a company offers a dividend to its stock holders, it is taking money that could be reinvested into the company, and distributing it to shareholders as a benefit of investing in the company. Receiving a dividend is good for investors, because they get a guaranteed return on their investment in the form of the money from the dividend. A stock that returns a dividend is good as an income investment or a long term growth investment. This is because these stocks tend to remain stable, and offer a tangible monetary benefit to investors.

Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

How does it work?

Dividend generally comprise of 3 factors:

• Amount - the money that you are getting as dividend from a company. This is generally represented as a percentage of the face value of the share of the company. For example, Hawkins Cooker recently offered a dividend of 200% i.e. Rs 20 per share (face value being Rs 10).
  
• Consistency - How often does a company offer dividends. As dividends are not guaranteed. It depends on the company if it wants to declare a dividend or wants to use the profits for some other purposes. A company that offers dividends consistently along with business growth is usually better as it is able to strike a balance between growth and share holder value.
  
• Timing - This is when would the dividend come into effect. Usually termed as Record Date, this is when all the shares held by any one would be considered for dividend. The point to note is, the shares should be with you before this date. One day after this date the share is termed as ex-dividend.

The other side of the coin

High dividends is not always a sign of good management. A company that needs to reinvest should not pay out all of its accounting profits in dividends. This will cause the productive capacity of the company to diminish and the company to eventually fall into bankruptcy. This actually is a technique of "corporate vultures". They buy a large controlling position in a fine company and purposefully pay far more dividends than they should. This causes the competitive position and productive capacity of the company to falter. This all takes a long time to happen and the company can rest on its laurels for a while. It takes outside analysts a long time to figure all this out. Accounting rules offer lots of scope to obscure what's going on The company is usually able to borrow money to pay dividends for quite a while before the market refuses to offer more credit. Then the inevitable day of reckoning eventually comes, but the "vulture" has already picked the bones clean before the death throes arrive.

The moral of the story is that it "pays dividends" to analyze the dividend record and dividend policy of a company.

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5 investing lessons from the T20 loss

There can be quite a few similarities between Cricket and Investments. Let us see what we, as investors, can learn from this:

1. Past perfect, future tense
In the T20 format, it is far more difficult to predict than in other longer formats. In the equity markets too, the shorter the time duration, the more difficult it is to predict. Just as how no fund manager knew at 21,000 sensex that the market can come down to 9,000, even those who claimed that they could predict, could never have predicted that from 8,700 market will move up 80 per cent in such a short time.

Lesson: Don't time the market. Invest regularly in a disciplined manner .

2. Strategy matters
Mahendra Singh Dhoni in 2007 was playing to win. In the year 2009 he was playing 'not to lose'. This made him very defensive.

Moreover, the top batsman had a limitation, they could not play the rising ball in England. The bowlers were not effective either.

Anil Kumble, Sachin Tendulkar were all available in England. The selection was poor.

Strategic mistakes in investing include
- too many funds
- choosing sectoral funds
- paying income tax on equity funds (by choosing a balance fund with 50% equity)
- not doing a SIP (systematic investment plan)
- investing a debt for a long term
- not taking adequate life insurance, etc.

These strategic mistakes hurt in the long run.

Lesson: Stick to the investing basics. Read about that here .

3. Never reward mistakes
Most actions are judged on outcomes, not on efforts. When Joginder singh was given the ball to bowl the last over there was no logic, but the result was stunning. So we called Dhoni a strategist. Now selecting Jadeja resulted in a loss. So we call him a failure.

Fund managers who sat on cash from 21,000 to 10,000 looked smart. That was a mistake we lauded. We called their performance as a ‘1st quartile performance’. However, when they sat on cash at 8,700 index waiting for the index to go to 6,500, they lost out. So the same heroes look like zeros!

Lesson: If you made a mistake, accept it and don't repeat it. It may have worked once but not always.

4. Overconfidence kills
Main causes of India’s failure were overconfidence, too many changes in the team, and playing defensive cricket.

Most retail investors struggle about which fund to keep and which to remove. The very simple thing to do is choose one fund and monitor progress. Also the need to transact is so high for the retail investor, that it hurts.

The same hurt you even while investing. Overconfidence (my techniques of last year will work this year), too many transactions, and keeping all your money in debt funds for 20 years.

Lesson: Be patient while investing.

5. Sharpen your skills
Even if you are a good tree cutter you need to take time to sharpen the axe. If you do not take time to think, rest, relax the muscles, how will you recover to play again? We over did our playing. What was the reason that we had a jaded team? Not sure. Many mutual funds tend to relax and rest on their past laurels. Look at their recent performance - it is really jaded!

Lesson: Keep learning

[source: moneycontrol]

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What is a Bonus Share

Reliance Industries has declared a Bonus issue of 1:1. WoW!!! But what does it mean? How does it affect me? Should I purchase RIL shares now?

We will try to get answers to these questions today.

What is a Bonus?

Free shares of stock given to current shareholders, based upon the number of shares that a shareholder owns. While this stock action increases the number of shares owned, it does not increase the total value. This is due to the fact that since the total number of shares increases, the ratio of number of shares held to number of shares outstanding remains constant.

Where did this bonus come from?

Bonus shares are issued by cashing in on the free reserves of the company. 

A company builds up its cash reserve by retaining part of its profit over the years (the part that is not used over the years to expand the capacity, pay the dividend etc.). After a while, this reserve increases, and the company wanting to issue bonus shares converts part of the reserve into capital.

So, the existing investor gets some free shares and the company's profit as well remains in-tact.

Affect of Bonus issue

A bonus issue adds to the total number of shares in the market.

Taking the case of RIL, the company has about 1,642.5 million shares outstanding. Now, with a bonus issue of 1:1, there will be another 1,642.5 million shares added. So now, there will be 3285 million shares.

This is referred to as a dilution in equity.

Now the earnings of the company will have to be divided by that many more shares.

Earnings Per Share = Net Profit/ Number of Shares

Since the profits remain the same but the number of shares has increased, the EPS will decline.

Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen.

That's because:

1. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.
2. A bonus issue is a signal that the company is in a position to service its larger equity. That means, the management would not have given these shares if it were not confident of being able to increase its profits and distribute dividends on all these shares in the future.

When does it take effect?

When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.

After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus.

Then how is this different from a share split?

In case of bonus shares the value of the share decreases proportionate to the number of bonus shares issued. For example, if the company issues bonus shares in ratio of 1:1 and the price of share is 900 , after bonus issue, the corresponding value of the share gets Rs. 450. Genreally company issues this in place of giving dividends. The market captalization doesn't get affected,  becuase if shares double,  the prices is halved.

In case of a split,  the face value of share decreases. Generally the face value of share is 10 Rs. but face value can be higher as well. So, if face value is Rs 10, then the  company can split the share in ratio of 10:1. Now the person holding 100 shares of rs 10 now will hold 1000 shares of Rs 1 each. now shares can be traded more frequently and this will in turn increase the liquidity of the share.

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RIL announces 1:1 bonus issue

Mukesh Ambani group firm Reliance Industries (RIL) today said it will issue one bonus share for every share held in the company.

The board of directors of the company at its meeting held today, recommended issuance of bonus shares in the ratio of one equity share of Rs 10 each for each share held, RIL said in a filing to the Bombay Stock Exchange (BSE).

The issue of bonus shares is subject to the shareholders' approval, it added.

The board has also declared a dividend of Rs 13 per fully paid-up equity share of Rs 10 of the company to the shareholders, the company said.

Shares of RIL today closed down 1.57 per cent at Rs 2,099 on the Bombay Stock Exchange.

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Gold: The best defence against recession

As worries over a global recession deepen, investors should now shift to gold as a safe haven.

History also supports this. In the great depression of 1929, Gold was the best performing asset. People had even dumped the currencies and converted to Gold with the fear of even central banks being fail. At that point in time, Gold was the standard on which each currency value was measured. Dollar was fully convertible to Gold and so were many other currencies.

Similar trends can be seen today with the upward movements in Gold prices, while the other asset classes are deteriorating in value. Analysts have confirmed, that the large investors and many hedge funds are dumping stocks and moving to the yellow metal on the fear of a global recession.

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History of Financial Crises

I found this nice article in The Hindu Business Line on the previous financial crises around the world. This is worth a look, so decided to post it here.

Not learning from history

Parvatha Vardhini C.

As the world struggles in the throes of a credit crisis, it seems appropriate to recount some (un)forgettable meltdowns of the twentieth century, the economics behind them and the panic that they created. Each of these major crises had features that have parallels in the current one. Yet, history repeats itself. Could investors have drawn a lesson or two from each of these and been more prudent? Read on.

The Japanese property bubble

The fall in property prices and defaults by sub-prime borrowers flagged off the now famous credit crisis. Will this crisis tip the world into recession? Let us hark back to the Japanese property bubble in the early 1980s.

At that time, Japan had huge trade surpluses (excess of exports over imports) with the US. Alarmed at its unfavourable Balance of Trade position, the US, through the Plaza Accord of 1985, allowed the yen to appreciate against the dollar. In two years’ time, the yen was up by almost 50 per cent.

The country’s export-dependent economy stumbled. Capital investments slowed. To avoid a recession, Japan eased restrictions on borrowings and progressively lowered interest rates. But low inflation (due to cheap imports and the fall in international oil prices), coupled with cheap money, enabled cash-flows into the property and stock markets as well.

Over the next few years, as demand for land increased, property prices soared. In the latter part of 1989, the Nikkei too raced towards its all-time high of 38,957 points but inflation had started to rear its head.

As the New Year dawned, the stock market nose-dived. The Bank of Japan sharply increased lending rates and placed restrictions on lending to the real estate sector. Property prices plummeted. Loans given with land as collateral went bad.

Soon, slowing investment and consumption led to deflation. Following the crash, the 1990s came to be known as ‘the lost decade’ in Japan. With the Asian financial crisis further rubbing salt into the wounds, Japan’s central bank adopted an extremely easy money policy that kept interest rates at virtually zero. Even today, at half a per cent, Japan has one of the lowest lending rates in the world. Little wonder that its central bank couldn’t cut rates earlier this week, alongside several other countries, in response to the US credit crisis!

Great Depression

The current credit crisis is increasingly being compared to the Great Depression in the US in the 1930s. The 1920s witnessed a huge increase in manufacturing output in the US. But the wages didn’t keep pace. Instead, the bulk of the profits was pocketed by corporates, creating a wide gap between the rich and the blue-collared.

At the same time, capacity expansions by companies (signalling higher profits), rising dividends and speculation drew surplus into the stock market. The upward spiral helped the Dow Jones Industrial Average hit a peak of 381 in September 1929.

When volatility rose, speculation gave way to fear and the party wound up quickly. The rich stopped spending. The poor, who were earlier financing their purchases mostly on credit, cut back. As demand declined, so did production. As a result, unemployment rose. Borrowers defaulted.

Ironically, it was the onset of World War II that boosted spending and bailed out the economy .

Asian crisis

If the Great Depression was born out of the unequal fruits of industrial prosperity, the Asian currency crisis of 1997-98 exposed the harm that volatile capital flows and highly leveraged positions can cause to entire economies. The years preceding the crisis saw South-east Asian economies such as Thailand, Malaysia and Indonesia open up their economies to foreign direct investments and capital flows.

Full capital mobility was allowed, with these Asian economies aligning their exchange rates closely with the dollar.

A sharp appreciation in the dollar in 1995 caused South-east Asian currencies to appreciate against other currencies as well. This resulted in significant losses on the export front — which was a key blow to these externally dependent economies.

A widening current account deficit (financed with overseas borrowings) coupled with basic differences in the economies of the US and these countries aroused speculation as to the ‘real’ exchange rate — the fixed exchange rate regime collapsed. As a result, the currencies of countries such as Thailand, Malaysia, Indonesia, Korea and Philippines were sharply devalued.

Interest rates were steeply raised to protect the local currencies. This set off a vicious spiral of rising cost of financing for companies and a squeeze on debt servicing capabilities. Earlier, the fixed exchange rates and the free flow of foreign funds had prompted domestic banks and corporates to borrow heavily from abroad.

Once disaster struck, the high leverage choked borrowers. Banks which resorted to borrowing from abroad for lending domestically too felt the heat. The excessive inflows had also found their way into asset classes such as the stock market and real estate.

When foreign investors began to pull money out, both stock market and real estate prices slumped. In the latter half of 1997, the IMF, along with the World Bank and the Asian Development Bank, provided aid to these countries as they were in danger of defaulting on their debt repayments.

These countries also agreed to undertake structural reforms by tightening their fiscal and monetary policies.

Latin American debt crisis

A similar story had already been enacted in Latin America in the 1980s. In the context of massive inflows of foreign capital and subsequent flight, the Asian crisis was, in fact, Latin America Part II.

The substantial increase in oil prices in 1973-74 by the OPEC nations resulted in massive inflows of surplus money into the oil-exporting countries. With the availability of funds far exceeding domestic requirements, these countries parked surplus funds in international commercial banks.

This happened at a time when countries such as Chile, Uruguay and Argentina had just liberalised trade and needed money to implement economic reforms.

Besides, oil-importing countries in this area also needed money to finance their deficits. So Latin America resorted to borrowing these surplus ‘petro-dollars’ from commercial banks whose loans were short-term and carried variable rates.

As the 1970s drew to a close, oil prices spiked again, fuelling inflation and, hence, higher interest rates. Money was needed to finance both the trade imbalance and the higher interest. For this, these countries resorted to fresh borrowings, and were thus pulled into a debt trap.

A year or two later, oil prices fell, but not interest rates. In Mexico, an oil-exporting country there was a flight of capital abroad. The peso depreciated by about 80 per cent; Mexico was unable to service its debt and was on the verge of defaulting on loan repayments.

Other Latin American countries followed suit. Further lending to these countries was refused and they could not get out of the debt trap. These nations were later forced to renegotiate their debt and the IMF stepped in to co-ordinate.

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Fixed Diposits: The safe Havens for the risk averse investors

As the Equity markets were on full swing last year, the good old fixed deposits and the post office schemes were loosing their sheen. But now that the markets have tumbled on their head and investors are looking for cover, it's once again time to look at these safest forms of money saving instruments.

Investors should go for bank deposits or Fixed Maturity Plans (FMP) of mutual funds which provide cushion and risk free returns during the uncertain times as now-a-days. These can be of paramount importance to senior citizens and to those with limited risk apetite.

Most Public sector banks are providing 10% p.a. for the fixed deposits (10.5% in case of senior citizens), which means you stand to earn Rs. 10,000 in a year on an FD of Rs. 100,000 pre-tax. The key aspect here is to protect your savings while keeping the returns modest.

FMPs are another way to invest in debt instuments. These are better than FD for the tax paying investors as they impose lesser tax penalty than a FD. FMPs are schemes from mutual funds that have a fixed tenure before they can be redeemed, much like the Fixed Deposits, but they provide you returns in terms of dividends that is taxed at 14% (Dividend Distribution Tax) whereas the FD is taxed at your respective income slab. 

It is always better to keep some portion of your investment portfolio in this instrument as well to keep your savings intact. 

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Interest Rates and stock markets

Interest is nothing but the cost you have to pay for the use of someone else's money. Credit users know this scenario quite well - they borrow money in order to buy something. When it comes to the stock market and the impact of interest rates, the term usually refers to something else.

The interest rate that applies to investors is the RBI bank rate. This is the cost that banks are charged for borrowing money from the RBI. It is the way the RBI attempts to control inflation.

What is Inflation?

Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase. By influencing the amount of money available for purchasing goods, the RBI can control inflation.

Basically, by increasing the bank rate, the RBI attempts to lower the supply of money by making it more expensive to obtain.

Effects of an Interest Rate Increase

When the RBI increases the bank rate, it becomes more expensive for banks to borrow money from the RBI.

The first indirect effect of an increased bank rate is that banks increase the rates that they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if they carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend, after paying the loan installments and bills for food, utilities and other essentials. This means that people will have less money to spend, which will affect the revenues and profits of businesses.

Businesses are also affected - When the banks make borrowing expensive, companies might not borrow as much and will pay a higher rate of interest on their existing loans. Less business spending can slow down the growth of a company, resulting in a decrease in profit.

Stock Price Effects

Changes in the bank rate thus leads to less spending and impacts corporate turnover & profits. If, a company is seen as cutting back on its growth spending or is making less profit - either through higher debt expenses or less revenue from consumers - then the estimated amount of future cash flows will drop. This will lower the price of the company's stock. If enough companies experience a decline in their stock prices, the whole market, or the SENSEX, will go down.

Investment Effects

For investors, a declining market or stock price is not a desirable outcome. Gains come from stock price appreciation, the payment of dividends - or both. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.

Furthermore, investing in stocks can be viewed as more risky compared to other investments in such as scenario. When the RBI raises the bank rate, freshly issued government securities, such Treasury bills and bonds, which considered as the safest investments will usually experience a corresponding increase in interest rates. In other words, the "risk-free" rate of return goes up, increasing the demand for these investments.

When people invest in stocks, they need to be compensated for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for investing in stocks is the sum of the risk-free rate and the risk premium. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks are not going to reward them adequately for the risk they have to take. Hence when the risk-reward for investing is against the investor, he will sell leading to fall in prices of stocks.

Views

Since around the last quarter of 2007 – rise in inflation, interest rates & all input costs along with the consistent lowering of GDP forecasts have clearly indicated the need for lowering expectations of returns from stocks. The risk-reward for investors in debt has improved and for stocks and real estate it has deteriorated. The recent volatility in gold prices, clearly hold no attraction as a haven for capital looking at a "flight to safety". The government finances are not in good shape. It is expected that the benchmark "risk-free" rate in the form of the 10 year GoI bond yield is likely to go up by 0.5 to 1%. This would definitely lead to increase in cost of all forms of capital with the highest impact being in the cost of equity which as our explanation confirms will lead to moderation in return expectations and hence valuations.

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Things to keep in mind while investing

Your journey towards financial freedom isn't complete without obstacles which you must learn to face and conquer. The sooner you learn to take action against them, more money you make.

Impulse Buying

Always buy when you see value not the price movements. Price movements are often due to market momentum and not for the value the stock presents.

Inflation

Inflation hurts people particularly those in fixed incomes like the elderly and those whose income isn't indexed to inflation. They lose a part of their purchasing powers because their cash flow remains constant while their cost of living increases. Employed individuals, despite receiving constant salary increments, are hurt because there is a time lag in compensation adjustments. By the time they receive higher nominal income, it has already been months since the prices of commodities went up.

Have a plan to buy assets which gain during inflation.

Procrastination

Procrastination simply refers to the habit of putting off doing something for a later time. Aside from the definition, it is also necessary to learn why we often choose to procrastinate. Is it simply because we are too lazy to act or is it something much deeper? More importantly, how do we get rid of this bad habit? What is the best way to really overcome procrastination?

Do today, what you can do tomorrow. Do now, what you can do today. This is the famous lesson that Ravana gave to Laxman in Ramayan while on the death bed.

Fear of Taking Risks

"Remember, life is a risk. To do or not to do something is an equal risk. And not doing something is the greatest risk of all. If you do it, you could lose . And if you don't do it, you will never know the benefits of having done it, or whether it will even work or not. So not risking is the greatest risk of all."

Wrong Beliefs About Money

If you think about it, money is simply defined as a tool that we use to acquire the things that we need or want. It is a non-living thing that is void of emotion or bias. Take a Rs 1000 note out of your purse right now and look at it. Would you agree with me if I say that you're simply holding a piece of paper? Can you shred it to pieces now ? No you would not.Yet we invest money into wrong places and throw our wealth into the sea.

Keep these things in mind and overcome them when taking investment decisions.

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Balanced Mutual Funds: Good option when Markets are down

What is a Balanced Fund?

Balanced funds a.k.a. hybrid funds are a type of funds which don't take full exposure either in equity or in debt. They invest in both equity and debt in a well defined ratio as per the fund's mandate. An investor with a low risk capacity and having dependents can use these funds to have stability in his/her portfolio.

They are usually classified in two broad categories:

Equity Oriented Hybrid Funds:

These funds usually invest in the ratio 60:40(equity : debt) or 75:25 (equity : debt). Suitable for investors who want to benefit from the equity market but at the same time would not like to risk his entire money with equities. These funds perform better than equity funds during the downturn in markets and have a better shield in terms of debt component.

In case of a downturn, they increase their debt component to reduce the impact of falling market in the fund's NAV.Similarly during a bull run, these funds will increase their equity exposure to get benefited from the bull run. So a moderate risk investor can choose this fund to have a balanced return.

Debt Oriented balanced Mutual Funds:

These have a big chunk(>70%) of their portfolio in debt instruments. These funds are designed to get returns from debt instruments but have a small portion invested in equities to get that additional kicker return to outpace typical fixed income instruments like bank FDs. In order to get an edge over typical debt instruments and also provide investor an extra bit of return, they have a limited exposure to equities.

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