Financial Mathematics -Calculating rate of returns before investment - Let's learn how

It's a common practice in financial industry that products are sold by projecting maturity value. Reason is human mind always looks at maturity value in today's term, but forget to measure impact of inflation and rise in expenses due to standard of living. We just get obsessed with the higher absolute value and forget the actual return it generates. Instead of focusing on maturity value if we start concentrating on returns we can take much better decision. Illustrating how just looking at maturity value can make our plans a haywire and that too when we actually in need of it.

One of my friend Vivek bought an Life Insurance policy for his son's education in the year 1999 for an 18 year term on becoming a proud father. The TOTAL cost for a good engineering course was almost Rs.40000 at that time.Let me remind you during late 90's a person at senior executive level used to get salary in range of Rs.20000 to 40000 pm. Household exps. for a family of 4 for an average middle class person was in the range of Rs.4000 to Rs.5000 pm. 

With an intention that his son should not compromise during his engineering studies he planned for an maturity of Rs.1 Lac, for which was required to pay premium of Rs.3000 equal to his one month Exp. or 75% of his monthly salary.

Inspite of planning for double the amount required. When his son will reach in STD 12th i.e in the year 2017, I doubt whether he would be able to pay even the tuition and entrance examination fees for engineering courses with maturity of above policy.

Biggest reason was he thought everything in 1999's context and he thought by paying Rs.3000 which was a big amount for him at that point in time he has secured his child's education.  As against that if he would have calculated the returns he might have understood its meager 7% per annum.

Let's learn how to calculate returns so that we do not face such problems.

Open an excel sheet and go on "Insert" select 'Function' under category select "Financial" and in window search for function type "Rate". The following box will appear after clicking OK.

Inputs ;

NPER is no. of period - In Vivek's case NPER is 18 years i.e tenure of payment. In case frequency of payment is Monthly multiply it by 12,in case of Quarterly by 4 and for Half yearly by 2.

PMT Payment - periodic payments or regular payment e.g Insurance Premium, EMI Installment, Monthly Post recurring Amt. etc.In case of an FD (Its Only 1 time Payment) so leave this filed blank.
In case of Vivek it is Rs.-3000.00. In case we are making payment that should be shown as (-) and receiving money should be shown as (+) or nothing.

PV - This field should be used in case of single or one time payment like for FD,Bonds, MF investment etc.In our case as it is periodic investment we will keep it blank.

FV - This is the desired corpus or the maturity amount product offers or required.As funds are flowing in we need not put any sign before it. 

Type - Applicable only in case of periodic or regular payment. In case you are paying in advance then you should put 1 and in case of end put 0.In our example it is 1 as we pay premium in advance.

Guess - It is not visible in above picture but in excel sheet when you will scroll down you will find it, no need to put anything in it. But in case any error comes then you should put approx. return which you think it would give. Most of the time you do not require to provide anything in this field.

Let's put above data and find the result which would be as follows :

You can see the Formula result as 7% at the bottom. In case frequency is taken as Half Yearly you need to multiply result with 2, for Quarterly by 4 and in case of Monthly by 12.

In this way you can calculate Interest on EMI and returns on FD, SIP, Insurance Policy etc...

While planning do not forget to consider effect of inflation and rise in exps. due to standard of leaving.

Great Investment opportunity for lower tax bracket or no tax individuals

Great news specially for senior citizens who are facing really hard time with their retirement funds because of high CPI inflation of almost 10%/Yr. for last 3 years and low interest rates.

RBI has atlast launched the much awaited Inflation Indexed National Savings Securities - Cumulative (IINSS-C) as promised. It is in continuation of Inflation indexed bonds (IIB) launched earlier. 

IIB's were targeted at large investors, so the markup- the additional payment over and above the inflation rate or the real coupon (interest) was arrived at via competitive bidding. RBI plans to pay this real Coupon on regular basis, then inflation component will be added to the principal and paid only at the time of redemption.

In a way it offers twin benefit first it protects the principal from inflation and you get the real value at maturity and second is an increase in cash inflow every year even when the real coupon rate remain constant.e.g. If Rs.1 Lakh invested in IIB and real coupon raet is 1.5% and the Whole sale price Inflation for 1st year is 5% then real payour for first year would be Rs.1500(1.5% of Rs.1 Lakh) and that for the 2nd year will be Rs.1575(1.5% of 1.05 Lakh).

But as the IIB were linked with WPI (Wholesale Price Index) it could not interest retail investors. As historically investors are more affected by CPI (Consumer Price Index) which is much above WPI. Like WPI for November was 7.52% whereas CPI was 11.24% i.e. a difference of 3.72%.

Now RBI has realised the same in the benefit of retail investors and has come up with IINSS-C (Inflation Indexed National Savings Securities - Cumulative) which is linked with combined CPI .Rbi has also avoided competitive bidding and markup fixed of 1.5% over CPI.

Obviously it is going to be a great instrument for the people who are in lower tax bracket or with non taxable income. I think they are the one who needs real protection from falling interest rates and rising inflation.

Appending below the scenario and benefits to investors :

IINSS-C Returns for difference tax Bracket Considering markup of 1.5% on base rate Tax Slab NIL Inflation Rate 8.00% 9% 10% Interest Rate 9.50% 10.50% 11.50% Effective Rate 8.00% 9.00% 10.00% Effective Rate due to half yly compounding 9.73% 10.78% 11.83% Tax Slab 10.30% Inflation Rate 8.00% 9% 10% Interest Rate 9.50% 10.50% 11.50% Effective Rate due to half yly compounding 8.73% 9.67% 10.61% Tax Slab 20.60% Inflation Rate 8.00% 9% 10% Interest Rate 9.50% 10.50% 11.50% Effective Rate 7.73% 8.56% 9.39% Tax Slab 30.90% Inflation Rate 8.00% 9% 10% Interest Rate 9.50% 10.50% 11.50% Effective Rate 6.72% 7.45% 8.17%

Now lets look at negative side - Interest is accrued and compounded every six months. Hence even though you do not receive interest tax has to be paid in each financial year.Looking at above calculation the IINSS will still not be that attractive for retail investors in higher tax bracket and also for senior citizen who requires regular income should avoid IINSS-C.

Instead of that it is better to invest in Tax free bonds, although it doesn't carry guarantee of Central bank.But with good credit rated bonds you have much better returns net of tax annually with much lower risk.

"SAFETY"- No such word in Financial Dictionary

As per dictionary.com meaning of safety defined as: the state of being safe; freedom from the occurrence or risk of injury, danger, or loss.

On Googling for meaning of SAFETY in financial terms, I could not find a single dictionary which explains - safety. I did found words like : safe harbour, safety net, safe heaven etc etc...and the meaning of any of them didn't matched with dictionary meaning.

Investopedia.com do define "safe assets" as 

"Assets which, in and of themselves, do not carry a high likelihood of lawsuit risk. Mere ownership of this type of asset does not expose the asset owner to a significant risk of litigation.

Assets such as stocks, mutual funds, bonds, bank accounts and your personal residence are examples of safe assets." Which is totally different from what Indian investor thinks.

The recent development of Cyprus prompted me to search for meaning of "SAFETY in financial world".

First let me take you through some facts about pattern of Investment of Indian investor - As per the RBI's 2011-12 annual report bank FD's or contractual savings(Small Savings Scheme, LIC) constitutes almost 85% of total financial savings where as currency is almost 10% leaving 4-5% for Equities. 

The obvious reason for such a high allocation to FD is SAFETY. We perceive word safety as "To get back the capital and Interest on maturity date without any volatility". That might be the reason we rely mostly on all the government institutions like : Post offices, LIC, PSU Banks.

But, fallout of some of the biggest bank and government institution in U.S and Europe are the best example that even Govt. institutions are riskier at times and we may end up losing part of our money. Why to go to U.S we have example of our own government sponsored UTI US'64 scheme wherein government did paid back money of investors but with a delay of 6 years and that too in the form of 6% tax free bonds.(Just think of condition of a father who had invested money for his son's education or daughter's marriage)

Regarding Guarantee for repayment of Bank FD, RBI portal says "The deposits kept in different branches of a bank are aggregated for the purpose of insurance cover and a maximum amount upto Rupees one lakh is paid."  subject to bank have paid premium to deposit insurance and credit guarantee corporation .

Now, Let's understand what has happened in Cyprus, just to bail out economy "Government has imposed tax on bank deposits in Cyprus, they are taxed @6.75% on their  deposits less then EURO 100000.00 and @9.75 for more then that ".In simple terms one fine day suddenly government reduced your bank balances as well as FD value by 6.75%- 9.75%. Just think how would you feel if you woke up in the morning and found that government has decided to take away 6.75% of your money".

Even in case of India it is happening that our FD are reduced by almost 4-5% every year. Let me explain you how : The current CPI inflation rate is about 10.50% and Tax free FD rates of SBI is 5.78% (8.50% less 32% Tax rate). So the cost of goods which I can purchase today for Rs.100 becomes Rs.110.50 (CPI@10.50%) at the end of year whereas my FD value net of tax comes to Rs.106.00. So to buy the same goods I need to add Rs.4.50 to my FD amount, don't you think even we are paying a tax of 4%-5% year on year on our bank FD.

The purpose of highlighting above facts is not that we should not invest in FD's but we need to understand that there is no such word as safe asset class. The fall of 15% in Gold in last 3 months has proved even the safest asset class can be volatile at times.

We are now a part of the global investor community. The purpose of an investor seating in other part of the world is to make profit from his investment. Wherever and whenever he finds an opportunity he will buy into it and sells out in case of uncertainty. He is not concerned with asset class i.e. Debt, Equity,Real Estate or Commodities like Gold,Silver,Oil,Copper etc...

So it is mere foolishness to think that price of your investment in any asset class can grow perpetually or safe from all risks.

The only way to save yourself from getting in trap of any asset class is to follow a proper asset allocation strategy (Also read ;key-to-wealth-creation-asset-allocation.)

looking at above facts we can either act like an Ostrich who hides his face in the sand when attacked by a predator (assuming that if you can't see it , then anyone else also don't see you) or can take informed decision of how much amount to be allocated to FD,Gold, Real Estate or Equity so that we or our family do not need to compromise on future Dreams or Goals.

Consult your financial planner to advise you on proper asset allocation.

God to India's rescue - Strong case to overweight Equity

Mannu Singh, who was in financial difficulty, walked into a temple and started to pray. ''Listen God -I know I haven't been perfect but I really need to win the lottery. I don't have a lot of money. Please help me out.'' He left the temple, a week went by, and he hadn't won the lottery, so he walked to a church ''Come on, God,'' he said. ''I really need this money. My mom needs surgery and I have bills to pay. Please let me win the lottery.'' a week went by, and he didn't win the lottery. So, he went to a mosque and started to pray again. ''You're starting to disappoint me, God,'' he said. ''I've prayed and prayed. If you just let me win the lottery, I'll be a better person. I don't have to win the jackpot, just enough to get me out of debt. I'll give some to charity, even. Just let me win the lottery.'' Many thought this did it, so he got up and walked outside.

The clouds opened up and a booming voice said, ''Mannu, my son please please please.....atleast buy a lottery ticket.''

Similar is the situation of India. Right now we want our growth to be in place, inflation to be under control, rupee to get stronger, get rid of corruption, reduce current account deficit, reduce fiscal deficit. 

By looking at India's Pathetic situation it seems god has felt pity on us and have bought a lottery ticket and served it to us on a platter.

The biggest worry for India as of now is twin deficits i.e. Current account deficit (CAD) and Fiscal deficit. Although our finance minister is making sincere efforts to control it, by increasing import duty on gold , reducing subsidies, cutting expenses etc. etc  but all efforts are in vain. 

It seems suddenly god has listened to prayers of all the Indians.

As mentioned in my earlier Blog  "Gold : Is it really safe anymore????" ( I did pointed out that gold can't keep on increasing and would see drastic fall when positions unwinds)  In its report RBI points out, as a ratio to the CAD, gold imports were a whopping 71.9 in FY12. As a proportion of the balance of trade, gold imports were 21% in the first half of FY13. So gold import is biggest negative for our balance of payment. With recent fall of almost 15% in gold prices will breathe a big sigh of relief and will improve our CAD.

Apart from gold another big worry for India is OIL. India imports over 70 per cent of its oil demand. So a 10% rise in oil prices result in a 0.6 percent fall in growth while in the full pass-through situation, it can reduce the growth by 0.9 percent and vice versa. The Best news is that even oil has corrected to sub $100 level for 1st time in 9 months is big positive for us.

Fall in prices of Gold as well as Oil will help us to bring down current account deficit, which will inturn strengthen our currency.

Subsidy on Diesel and Kerosene adds up to our Fiscal deficit and increases inflation. So fall in oil prices also narrows down the fiscal deficit as well as inflation.

Icing on the cake is that WPI inflation has fallen to 40 month low of 5.96%.

From the above facts I strongly feel that RBI has to completely change its focus from fighting inflation to growth, which will help in generating jobs and help corporates to grow. We can expect rate cuts from RBI in policy review due on May 3rd.

All the biggest concern as far equity market is already addressed by falling Gold Prices,Oil Prices and Inflation which lays down a strong foundation for start of a new bull run. I don't say that market will start performing immediately. But, from asset allocation point of view it is time tor rebalance your portfolio and if your are into tactical asset allocation its time to be overweight on equities.

Key to WEALTH CREATION - Asset Allocation

Asset allocation plays a key role in every investors financial planning.

If, I get a chance to own a IPL Team "Dream Achievers'. How should I go for buying players,during auction.Should I buy all 15 team members as Fast Bowlers or All Rounders or Spinners or Hard Hitters. No, I need to make strategy looking at different options available, their pricing and my budget. According to that I will buy 7-8 good Batsman, 2-3 Spinners, Obviously a Wicket Keeper and 4-5 Fast bowlers, Possibly 2-3 of them being all rounders.

Depending on the ground conditions and opponent I decide the final team on the Jumping Japak Jumpak Jumpak. I might have 3 spinners and 2 pacers or 4 pacer and 1 spinner might send opener as Mr.Pinch hitter or Mr.Reliable. So I  need to put in place some strategy in buying the players as well as before start of the match.

Similarly in investments, all asset classes doesn't work at all the time, But perform in cycles. Hence if one were to invest all his savings in a single asset class then certainly he is inviting a big trouble for his future.As we all know world of finance is very uncertain and sticking to your asset allocation hold the key to success. 

Financial Planners uses asset allocation strategies not only to create wealth, but also to protect it during volatile times. It is not the maximisation of returns, but optimisation of returns that becomes the goal. This process plays a key role in determining the risk and return from your portfolio. Broadly speaking, the portfolio’s asset mix should reflect your risk taking capacities and goals. Financial Planners use different strategies of building asset allocations, some of them as follows :

Strategic Asset Allocation

Strategic allocation is typically the first stage in the investment process. Based on the investor’s long-term objectives, an initial portfolio is build. It is the backbone of any investment strategy. This often forms the basic framework of an investor’s portfolio. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically given a return of 14% per year and bonds have returned 8% per year, a mix of 50% stocks and 50% bonds would be expected to return 11% per year. Strategic asset allocation generally implies a buy-and-hold strategy. Strategic asset allocation defines the boundary of risk, and it is these boundaries that help control portfolio risk.

Constant-Weighting Asset Allocation

Strategic asset allocation has its drawbacks as it entails a buy-and-hold strategy even if a change in the value of assets causes a drift from the initially established policy mix.The constant weighing strategy helps you to continuously rebalance your portfolio. For example, if gold was declining in value, you would purchase more of it to maintain its weightage and if its value increased you should sell it. There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. Most Planners advises rebalancing to its original mix when any asset class moves more than 5-7% from its original value or alternatively on semi annual basis.

Tactical Asset Allocation

Most of the Indian investor I have follows this allocation strategy without knowing risk associated with it. There are investors who constantly want to seek returns out of market opportunities that arise. Hence, they go in for short term tactical calls. Such tactical calls create room for capitalising on unusual or exceptional investment opportunities. This is like timing the market to participate in the fluctuations and volatility that arise due to market conditions. For example, shifting a part of the portfolio from large cap stocks to mid cap stocks to take advantage of the environment is a tactical call. Tactical allocations being opportunistic in nature, Investor are advised to always prefer to maintain clear time-based and value-based entry and exit points to ensure better management. Personally, I feel it is impossible to time the market on long term basis, it is something like predicting future and one wrong call can affect your financial plan drastically.

Dynamic Asset Allocation

It is for aggressive investors who want to ride momentum at times. So, if the stock market is showing weakness, investor sell anticipating a further fall. If it is going up, he buys anticipating a further rise. Here you constantly adjust the mix of assets as markets rise and fall. This is the opposite of constant-weighting strategy. As the entire portfolio is available for action, amateur investors may turn hyper active. Especially in the high volatile times, acting on all types of information can lead to high transaction costs. Also, the tax treatment of the returns turns to disadvantages if you churn your portfolio too much. 

Finally, victory of match depends on the strategy applied by captain in selecting the players as well as ground (market) conditions.

Similarly, to achieve financial goals as well as creating wealth every investor need to follow the asset allocation strategy and stick to it in different market conditions.Financial planners plays a big role in helping them to select a strategy which suits their risk profile and tries to bring in required discipline.

U.S.NRI's - Investments from INDIA are no more TAX FREE

Lots of U.S.NRI investors invests in India (non-US) mutual funds, bonds and various types of “life insurance” products (the latter are often a fancy version of a foreign mutual fund investment).  Sadly, these investors are often taken in by the sales pitch of investment advisors unfamiliar with latest US tax laws.  The sales pitch focuses on the fact that the investment can grow tax- free for many years. While it is true that no tax may be payable in the fund’s jurisdiction (Nil Long term capital gain for Equity for instance), significant US taxes are payable by the US NRI's owner under the so-called “passive foreign investment company” or  “PFIC” rules.

The latest IRS announcement regarding the annual reporting of PFICs as mandated by tax laws enacted in President Obama’s first term.  The Foreign Account Tax Compliance Act (FATCA) enacted in 2010 had numerous provisions. One of them mandated that US owners of PFICs (whether such ownership is direct or indirect) must annually report significant information to the IRS(Internal Revenue Service U.S). This annual report was to be made on Form 8621. 

What is a PFIC and What Does it Mean If you Have One?

More often than not, the foreign mutual fund or similar investment will be characterized as a PFIC. A PFIC includes any non-US corporation if 75% or more of its gross income for the year consists of “passive income”.  Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. Just about all of the income of a fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs!

Don’t Mind Losing Your Investment? PFIC Means Very Harsh Tax Consequences

Form 8621-This is the form you would need to fill up if you have mutual fund holdings in an Indian mutual fund company. The form gives you several options to declare the notional appreciation. Let's take a look at the options relevant for a retail mutual fund investor:

Option 1: Election to mark-to-market PFIC

This is the most common option for Indian mutual fund investments. "Broadly speaking, according to this option, you must declare as income the notional gains in the market value of your fund holdings during the year."

Here is what typically happens:

- In the year of purchase, the gains are the difference between market value at the end of the year and cost of purchase.

- In the subsequent years, the gains are the difference between market value at the end of the year and 'adjusted basis'. Adjusted basis is usually the market value in the beginning of the year. In case there is a loss, the loss can be set off against foreign PFIC notional gains of only the previous years. Any loss that is not set off is added back to the adjusted basis of the next year. So for instance, if in year 1 you incurred a notional gain of $100 on your PFIC, $100 would be taxed as ordinary income in year

Suppose your loss in year 2 was $150. In year 2, you would be allowed to deduct a loss of $100 from your total income (loss to the extent of gains taxed earlier).

- When the units are actually sold, you will be taxed long term capital gains only on the portion of gains that has not been taxed in previous years as ordinary income

Option 2: Election to treat as QEF - Qualified Electing Fund

"This option is commonly used in case of investments by US residents and citizens in offshore private equity funds,"

A QEF is taxed like a partnership wherein each investor is considered to have a share in the total profits of the fund. You can exercise this option only if the foreign fund agrees to share information with you about your share of profits.

Option 3: Excessive distribution method

"This is a default election. If you opt out of all other options, you will be taxed as per this option, which is also the most taxing,"

He adds, "According to this option, the distributions in the current year should be

at least 125% of the average distributions of last 3 years. The logic being that you are receiving incremental income every year from the fund and therefore not trying to defer taxes. If you do not meet this condition, then the total distributions are allocated over the entire holding period and taxed in each year at the highest tax rate of that year. Not only that, you will also be charged interest on each year's tax liability."

What this means: Suppose you did not make any election on your PFICs and throughout the holding period, did not fill up Form 8621 for your PFIC holdings.

You held the PFIC units for say 10 years and did not receive any distributions during these 10 years. In the year of sale, you made a gain of $100. In the year of sale, your gains will be distributed over the past 10 years, that is, $10 per year. It will be treated as though you did not pay tax on $10 per year and hence in year 10, you must pay tax for each of these years plus interest on the delay. You will have to fill up part IV of Form 8621.

Just in case you are thinking of ‘ignoring’ the rules regarding self-reporting on PFICs, please note that under other provisions of FATCA, ”foreign financial institutions” will be required to report directly to the IRS about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 8621 to determine whether taxes and reporting on the foreign fund have been properly undertaken.

Owning a house or business "OH MY GOD"

After a long time got opportunity to watch a fantastic movie "OH MY GOD". There are certain movies like Munnabhai MBBS, 3idiots, Rang De Basanti, Tare Zameen Par , can shake you inside. It has power to bring in the change required.

Huge success of above movies confirmed that Indian society is ready to appraise the libertarian attitude and the Indian  youth is daring enough to raise the issues of collectivistic problems and is ready to denounce them, to fight against them.

I know this is not a movie review blog, but together with certain other facts shown in the movie "OH MY GOD" a very relevant point related to your financial planning is also been highlighted and that is insuring your HOUSE as well as your BUSINESS.

The biggest asset an individual builds during his life is his own house and business. A small accident can wipe out your earnings of life. How many of us have overlooked at insuring these investments? The requirement of home insurance is overlooked and understated in India.

While owning a house today, what youngsters forget is the protection of their property. The financial institutions providing housing loans ensure that the individual gets himself a home loan protection policy but no one ever bothers to insure the house that is being bought. There are many convenient options available in the market that helps one not only insure the property but also the belongings.

Let's know home insurance

Home insurance plans allow you to protect your house and household items against fire and other perils, such as theft, burglary, accidental breakdowns and so on. If you intend to buy house holders' insurance, you should buy a policy that provides cover for your house as well as contents in it.

Points to remember before buying home insurance

Make sure that you read and understand the policy coverage, exceptions, exclusions in the plan. So that you don't end up like Kanjibhai in the movie. Your cover therefore, should include your house, belongings, liability to others if some mishap occurs and your living exps., if you are forced to stay in rented house. Basically, if a disaster occurs, your policy should help you to rebuild your home and replace its contents.

Take an inventory of your possessions. If you have to file a claim, two things need to be done - prove you own certain items and verify their value. Some insurance companies advise clients to go through their homes with a video camera, walk through each room, and ensure that you have everything you own, recorded.

Always make sure that you update your policy value to cover various assets that you might add to your house as well as taking care of rate of inflation.

Eligibility

Any resident Indian who is owner and/or occupant of the property can purchase a home insurance policy.

Coverage

The covers provided are :

Fire and Allied Perils - Building and Contents , Burglary (optional), Unlike shown in movie you can also take a cover for earthquake by paying additional nominal premium.

Key features

An individual with an independent house or a flat can opt for this benefit and applicable to any residential building.It covers building against risks like Fire,Lightning,Storm, Riots, Strike and Malicious damage.

In city like vadodara an house with construction area of 2500 sq.ft considering construction cost be Rs1000/sq.ft , Total cost Rs.2500000.00 you need to pay an annual premium in the range of 1300 to 1400.

Remember to cover your house for construction cost and not for the value at which you bought, as it also includes cost of land.

So, put your house insurance to be on top priority.

Unravelling NCD's (Non Convertible Debentures)

We as an investor are always tempted by higher returns, specially in a time when interest rates offered on bank FD have move down in the range of 8.5 -9 % without knowing risk associated with it.

Another such wave of offering higher returns on your investment is about to come in the form of NCD's or Non Convertible Debenture. But as we are going to invest our hard earned money we need to know nitty gritty of the instrument.

Let's understand what NCD's are:

Whenever a corporate wants to raise money from public they issue a debt paper which is for a specified period and pays a fixed interest this debt paper are known as debentures . Debentures can be convertible as well as Non convertible.

Convertible Debentures : The Debentures which pays interest at fixed rate and on maturity date are converted to Shares of the company are convertible debentures.

Non Convertible Debentures : The Debentures which pays interest at fixed rate and on maturity returns the  capital amount are NCD.

Even NCD's can be of 2 types :

• Secured Debentures : As an security it is backed by asset of the company and if it fails to pay, the investor holding the debentures can claim it through liquidation of the assets.
• Unsecured Debentures : Contrary to above it is not backed by any security in case company defaults the amount would be paid only if any amount left after paying off for the secured creditors.

Features of NCD

NCD's normally works more or less like company deposits. One advantage of NCD is they are listed on stock exchange and theoretically speaking they provide liquidity.However, there is no active market for NCDs on the wholesale debt market segment of the stock exchanges and their liquidity is low. You might not be able to find a buyer for your NCDs if their trade volumes on bourses are insignificant.

Any Indian company can raise money through NCDs if it has a tangible net worth of at least Rs 4 crore and has been sanctioned loans by banks or financial institutions which is classified as 'standard asset' and not as bad debt.

Companies seeking to raise money through NCDs have to get their issue rated by agencies such as CRISIL, ICRA, CARE and Fitch Ratings. NCDs with higher ratings are safer as this means the issuer has the ability to service its debt on time and carries lower default risk.But the rating provided is at the time of issuance and may change during the tenure.

Interest rates on NCD

Normally NCD provides a higher interest rate then the market or Bank FD and comes with long tenure. Best suited for individuals who have  lower risk profile to build their retirement corpus and also for retirees during low interest rate scenario. NCD's come with lot of interest payment options viz; monthly, quarterly, annually and Cumulative. 

Interest rates also depends on rating of the issue. Lower rating means higher interest rate and vice versa.

Taxation

Interest on NCD do not attract TDS, but interest is taxable and is added to income for that year.

Capital Gain :

NCD's are listed on stock exchange and if sold on exchange it is taxed like debt fund. If sold before 1 year,  profit will be added to income and taxed at per tax slab. But any profit made selling after 1 year and before maturity would be taxed as long term capital gain. The applicable tax rate is 10.30% without indexation.

Risk involved 

NCD has some inherent risk. Investor need to check companies financial and end uses of the funds. Checking for rating can help a bit. 

Many a times we have seen that although the issue is secured but is backed by assets which may fluctuate in valuation. Like if we take case of Gold finance company mainly engaged in finance against Gold, comes with  secured NCD's backed by asset (Gold) as guarantee. 

As we know that gold has also become an speculative asset and if there is any major fall in prices of Gold. The company might not be able to recover its loan, due to which loan default rate might increase. It may result in default of NCD payment. Investors would not be able to recover their NCD value inspite of being secured as even after liquidation of asset i.e gold the amount recovered would be much less.

Please consult your financial advisor before investing in any such instrument.

Misleading Advertisment of SBI Bank FD

Be cautious of misleading advertisement published by SBI in all leading news paper showing annualised yield of 17.77% on 5 Year tax saving Fixed deposit.
 

It considers investor to be in the highest tax bracket and also that 80C limit of Rs.100000.00 is not exhausted. It also doesn't consider taxability of interest earned.

PPF is still a better option if you wish to invest for tax saving as the interest earned would by 8.6% (subject to change every year but much better then SBI FD) as compared to tax free interest of above FD i.e 6.39% (9.25 less 30.9% of 9.25%)