Tag: interest rate

Why tax-free bonds are a good alternative to bank FDs

Personal Finance

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With interest rates at historic lows today, investors looking for better-return, fixed-income options can consider tax-free bonds available in the secondary market. These bonds can be a relatively low-risk alternative to many bank fixed deposits for those in the higher tax brackets.

Tax-free bonds

Tax-free bonds are issued by public sector undertakings such as NHAI, HUDCO, PFC, REC, IRFC, with maturities of 10 years or longer. The last primary bond issue was in March 2016. You can buy these bonds from the secondary market. They are listed on the BSE and the NSE.

‘Tax-free’ here refers only to the tax-free interest. That is, you don’t have to pay any tax on the interest (coupon) received on these bonds. These bonds are not included under Section 80C (Income Tax Act) investments and the money invested in them is not eligible for deduction from your taxable income. The interest on such bonds (paid out periodically) is tax-exempt while that on fixed deposits is taxed at your income tax slab rate.

Note though that while tax-free bonds from certain issuers may enjoy good trading volumes, if you have large bond holdings (of say a few crores of rupees), you may need a few days to a week to exit your holdings completely. “Monitoring of price (and hence yield) and volume of past 1-2 months is required before investing,” says Deepak Jasani, Head of Retail Research, HDFC securities. Liquidity may, however, be less of a concern for those with smaller investments.

 

What bonds to choose

Given the current interest rates, further rate cuts don’t appear likely. To avoid missing out on higher returns once the rate cycle starts turning up gradually, you can invest in tax-free bonds (that have good trading volumes) with a residual maturity of around two years that offer the best yield-to-maturity (YTM). Also, it’s best to stick to AAA-rated bonds (a few are rated below AAA) as they come with the highest degree of safety.

Data from HDFC securities show that AAA-rated IIFCL bonds (series -719IIFCL23) priced at ₹1,114 per bond, with a residual maturity of 2.2 years and daily average trading volumes of 2,557, offer a YTM of 4.71 per cent. The YTM shows your return from a bond if you hold it until maturity.

Do note that YTM calculations assume that interest from a bond is getting reinvested at the same current yield. Tax-free bonds make periodic interest payouts to investors. So, depending on the rate at which these are reinvested, your actual return can be lower / higher than the YTM. For a bond with a relatively shorter residual maturity such as two years, this impact may, however, be very small.

If you sell the bond before maturity, your final return will also depend on the selling price versus the purchase price of the bond. This could result in a capital gain or loss for you – which is the interest rate risk.

Risk return trade-off

While tax-free bonds may not carry as low a risk as many bank fixed deposits do, the AAA-rated bonds do offer a good degree of safety. Unlike bonds, fixed deposits carry no interest rate risk – that is, the value of the original investment remains unchanged. Also, while tax-free bonds may not be perfectly liquid (for large holdings), fixed deposits can be liquidated any time, though subject to a penalty in many cases.

That said, tax-free bonds are issued by public sector undertakings that enjoy Government of India backing. So, they carry low risk of default and can be considered safe.

Who should invest

Investors who are not completely risk averse and are in the 30 per cent tax bracket, can invest in the IIFCL tax-free bonds as an alternative to many public and private sector bank, and small finance bank FDs that are offering lower post-tax returns (see table). Those in the 20 per cent tax bracket, can invest in the bonds as an alternative to some lower-interest rate offering of public and private sector bank FDs.

You can buy and sell tax-free bonds through your demat account. Sale of tax-free bonds attracts capital gains tax. If you sell the bonds within 12 months from the date of purchase, you are taxed on the gains based on your income-tax slab rate. If the bonds are sold after 12 months, the gains are taxed at 10 per cent without indexation benefit or at 20 per cent with indexation benefit.

Floating rate bonds

Another safe investment option for those wanting to diversify from bank FDs are the Floating Rate Savings Bonds 2020 issued by the Central government.

These bonds make semi-annual interest payments which are taxed as per your slab rate, and can be bought from some of the leading banks. The current interest rate on them is 7.15 per cent and is payable in January 2021. The interest rate is reset every six months. These bonds look attractive given that interest rates are expected to gradually move up. The only negative here is the long lock-in period of seven years.

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Know the magic of compounding

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A phone call between two friends leads to a conversation on how compound interest works.

Karthik: If not for Covid-19, we would have planned a trip this December, no? Phew!

Akhila: How I miss travelling!

Karthik: The silver lining is that I’ve saved a few bucks from limiting my travel this year.

Akhila: So, are you planning to invest that money?

Karthik: No, yaar! It’s too little to invest. Even if I do, the interest I earn on it will be peanuts.

Akhila: No, you’ve got it wrong. The return that you may earn today may be small, but if you stay invested over a long term, the power of compounding will result in bigger gains.

Karthik: The word compounding rings a bell. Care to explain?

Akhila: Sure. As Benjamin Franklin explained compounding: “Money makes money. And the money that money makes, makes money.”

Karthik: Whoa! Sounds like a tongue twister! Explain it in simple terms, no?

Akhila: When you invest, your principal amount earns interest in the first year. In the next year, you earn interest on the principal as well as on the interest earned in the first year. In the following year, you earn interest on the principal and on the interest earned in the first two years and so on.

Karthik: – That’s amazing!

Akhila: – To give you some perspective, any amount invested at 10 ten per cent per annum takes about 10 ten years to double if the interest is credited based on simple interest. But if the interest is compounded yearly, the investment doubles in just about 7.3 years!

Karthik: – Interesting…

Akhila: That’s the miracle of compounding. So, will you invest now to unlock the value of compounding in the long run?

Karthik: Of course! I have been waiting all life for a miracle to happen. Never thought it will be through compounding.

Akhila: Good! But, you also need to remember that compound interest can also be your greatest enemy.

Karthik: Oops!

Akhila: That is when you do not repay your loans on time. Any interest on your loan, if not paid by the due date, attracts interest. If the dues are not paid for a long period, the outstanding loan amount can snowball into a mountain of unmanageable debt.

Karthik: Real killer.

Akhila: As the popular saying goes: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Karthik: That’s Simply Put.

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How yield on deposits is calculated

Personal Finance

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Angry bird Bulbul gets some ‘interesting’ gyaan from agony uncle Babaji who revels in rhyme and reason

Bulbul: Businessmen always get what they want. Cheaper loans they asked for – and now they have it, with interest rates at multi-year lows. But in the bargain, savers and depositors like me are getting squeezed – most banks and companies now offer just about 5-7 per cent on fixed deposits. Not fair!

Babaji: Fret not so much, Bul. What goes up comes down and what goes down comes up. So will interest rates. It’s all temporary.

Bulbul: Whatever, Baba. But for now, I am on a hunt – for the best yields to shore up my already modest interest income.

Babaji: Hunt if you must, but don’t fall for illusions. ‘Cos what you see may not be what you get – especially when it comes to yield in this fickle financial field.

Bulbul: Another rhyming riddle and your fate is sealed! See this baton that I wield?

Babaji: Calm down, Bul. Let me make the complex simple, and see your smiling dimple. You see, when it comes to interest and yields, the simple can compound your problems. It gives you an illusion of more, and you could end up feeling sore.

Bulbul: Now, do you really want a gash and a gore?

Babaji: Nope, here’s the crux to the fore. When it comes to advertised yields, what you see is often an exaggerated number meant to entice you, dear depositor. That’s because many companies that accept deposits do not follow the correct definition of yield.

Bulbul: Pray, explain what you say.

Babaji: Yield, as per finance terminology, should ideally be calculated using the formula for compound interest, that is, Amount = Principal*(1 + Rate)^Period. But several deposit-takers calculate yield applying the simple interest equation, that is, Simple interest = (Principal*Period*Rate)/100. Re-arranging the formulae, the Rate in both the equations gives you the annual yield. Turns out, the simple interest formula churns out a much higher yield than the compound interest formula.

Bulbul: Oh my! Tell me why.

Babaji: Sure, let me try. In a cumulative deposit, the interest earned is reinvested and, in turn, earns interest in the subsequent period. These periodic additions to the capital need to be considered while calculating yield. The compound interest formula does that, the simple interest one does not.

Bulbul: Yelp! An example will help.

Babaji: Say, a company offers annual interest rate of 6.7 per cent on its cumulative deposits for a tenure of 5 years; the interest is compounded annually and Rs 5,000 will grow to Rs 6,915 in 5 years. The company advertises that the yield is 7.66 per cent, using the simple interest formula – while actually, the yield is only 6.7 per cent using the compound interest formula. If you get enamoured by the higher advertised yield, you could end up making a wrong choice. Greed often comes with misery, you know.

Bulbul: Enlightened, thanks. But how do I calculate the correct yield without getting into knots with complex formulae?

Babaji: Simple. Invoke the ‘Rate’ function in Microsoft Excel. It can do the job in a jiffy. Before you take the bait, wait and calculate.

Bulbul: That’s Simply Put.

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What are the less risky options for higher returns on your FDs

Personal Finance

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My wife has a fixed deposit of ₹3-lakh in Dena Bank. Now, with the merger of the bank with Bank of Baroda, we would like to discontinue it and switch it over to some other bank. On checking with Indian Overseas Bank, we found they offer 5.2 per cent for 3- to 5- year tenures . I am looking to invest with a horizon of 3-5 years in a safe and less risky asset with a 7 to 8 per cent yield. Please suggest a suitable investment avenue.

— N.P. Desai

Given that the full financial impact of Covid-related moratoriums and concessions on bank financials is not yet known, it is best to stick to larger and financially stronger banks and NBFCs for deposits at this juncture. Switching your deposit out of Bank of Baroda into Indian Overseas Bank (IOB) for a 5.2 per cent rate is not a prudent course of action in this context as Bank of Baroda is a stronger and larger bank. In the quarter ended September 2020, IOB had reported net profits of ₹148 crore, managing a turnaround from losses in the previous year, with gross NPAs of over 13 per cent and capital adequacy ratio of 10.9 per cent. The bank was also placed under RBI’s Prompt Corrective Action framework.

Bank of Baroda, apart from being consistently profitable, had comfortable capital adequacy of 13.2 per cent as of the same date. Given that RBI’s policy rates today are at their lowest levels in two decades at 4 per cent and market interest rates for highly rated entities are at rock-bottom too, you can get a 7 to 8 per cent return only from riskier entities. Given that the rates may go up at least a bit once the economic situation normalises from Covid, locking into these low rates for periods beyond a year is not advisable. Therefore, it is best not to consider 3- to 5-year fixed deposits currently and stick with up to 1 year deposits even if rates seem unappealing.

Having said this, we can suggest three courses of action given the situation. If you would like a slightly higher yield on your fixed deposits, you can consider the one-year post office time deposits offering 5.5 per cent which offer superior safety with a higher return. If you really seek higher returns and don’t mind some risks with it, you can stay with Bank of Baroda for some of your money and diversify into 1- year deposits from small finance banks such as Equitas for say, one-third of the money. Such banks, however, do lend to riskier segments of small borrowers and, therefore, your deposits are subject to higher risks than with the leading commercial banks like Bank of Baroda.

Deposits with top-rated NBFCs such as Sundaram Finance or HDFC which offer about 5.7 per cent on cumulative deposits of up to 1 year can also be an option. If monthly income is your objective, the Post Office Monthly Income Account offering 6.6 per cent is an option to look at too, though the long lock-in of five years is a deterrent. If your wife is a senior citizen you can also consider the post office senior citizens savings scheme offering 7.4 per cent, albeit with a 5-year lock-in period.

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How the MPC’s policy rates matter to you

Personal Finance

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Banker Balu’s long spell in front of the TV provoked his daughter Malathi into asking some questions.

Malathi: Dad, for God’s sake, stop watching that boring stuff and let me get to Netflix. How on earth is this speech on repo, Marginal Standing Facility, etc., useful to us!

Balu: Remember your savings account? Recall that fat education loan I took? The MPC’s decisions determine what rates you’ll earn on that deposit and what rates I’ll pay on your loan.

Malathi: Okay, if it’s about your money, I’m interested. What’s this repo and reverse repo rate thing which they’ve not changed?

Balu: The repo rate, short for repurchase rate, is the rate at which banks borrow quick money from the RBI, when they’re a little short of funds. The RBI keeps a special window called the liquidity adjustment facility (LAF) open for just this purpose.

Malathi: Don’t tell me banks run short of money and go broke!

Balu: He he! Sometimes they do, like one bank I won’t name. But we bankers often face temporary mismatches between our deposit inflows, repayments and loan outflows, which we try to plug with LAF. When we have extra money, we deposit it with the RBI at the reverse repo. Don’t you run to me to top up your account at month-ends?

Malathi: So, banks can simply walk up to the RBI and ask for money. Sounds lovely! Please open an LAF window for me, Daddy.

Balu: Sure, give me your smartphone as security. The RBI doesn’t hand out money to banks, it takes government bonds as collateral.

Malathi: Fat chance! The MPC just said that the repo rate is at 4 per cent. So, banks can borrow tonnes of money at 4 per cent and give us loans at 12 per cent? Now I know why you’re a banker.

Balu: The RBI allows banks to borrow from LAF upto a small fraction of their deposits, usually 0.25 per cent. If they need extra funds, they need to tap into the RBI’s Marginal Standing Facility, or MSF, at a higher rate.

Malathi: Why does this MPC tinker with the repo, MSF, etc? Can’t it just set them once and for all?

Balu: The MPC has to ensure that inflation doesn’t go out of control. So it regulates the price of the money – the interest rate.

When the price of money is high, there’s less of it chasing goods and services and presto, you have less inflation.

Malathi: But do repo changes affect our loans too?

Balu: Yes, your education loan is at 2 per cent over the banks’ lending rate, which is called MCLR. So, if the bank raises its MCLR, the loan becomes more expensive. But deposits will fetch me a little more, too, as my savings account rate is based on the repo rate.

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