Saturday, May 25, 2013

Inflation Indexed Bond

The RBI has launched inflation-indexed bonds (IIBs) to cushion your savings against rising prices. These financial instruments are meant to encourage savings and wean investors away from gold.

Why we need IIBs
Inflation erodes the purchasing power of money. Most debt products such as fixed deposits (FDs) or regular bonds provide returns that are not protected against inflation. If a bank FD pays an interest rate of 8.5% p.a.and inflation averages 9.5% that year, the investors loses money in real terms.This is where IIBs T come handy. These bonds adjust the principal investment to the inflation so that the investors earns a higher interest. For example, if a 10-year bond has a face value of 1000/- and the annual coupon rate is 10%, then investor will get 100/-. Now, if the inflation index in the next year rises by 12%, the principal will be adjusted the inflation rate and get raised to 1,120/- [1,000 * (1+12)%]. So, the next year the investor will earn 112/- as interest, which is 12% higher than the original amount. The way the returns from the investment will be safe from the incessant march of rising prices.

The calculations
The Wholesale Price Index will be used for adjusting the principal. The calculation will take the WPI index with four months' lag. For example, the final WPI for December 2012 and January 2013 will be used as reference WPI for adjusting the principal on 1 June, 2013 and 1 July, 2013 respectively. On maturity, the investor gets back the higher of the adjusted principal or the face value.

The disadvantages
Although inflation-indexed bonds prove beneficial during times of high inflation, they under-perform when the economy goes through a deflationary phase and prices actually come down. In such situation, the IIB will give lower than coupon rate because the principal would get adjusted below 1000/-. However, this is only a theoretical risk. A decline in whole-sale prices is not even a remote possibility in India.
Another drawback of these bonds is that they have been indexed to the WPI and not the Consumer Price Index (CPI). For most investors in bonds, the CPI is the more relevant index. Consumer prices matter to them in day-to-day life than wholesale prices. 

Can these Bonds beat inflation?
  • Inflation -indexed bonds were first issued in the UK in 1981 and became popular in other countries as well over the past two decades.
  • In the US they are referred to as TIPS (Treasury Inflation Protected Securities) and form an important part of investor portfolios.
  • In India, the Capital Index Bonds 2002 were issued in December 1997. But only principal repayments at the time of redemption were indexed to inflation.
  • With the launch of these bonds, more investors may not opt to save via a financial instrument instead of buying gold.
  • One big drawback is that these inflation busting bonds are linked to the WPI and not the more relevant CPI.

Sunday, May 19, 2013

Hoarders vs Investors

How hoarders can make a transition to investors

Enough has been written about investors' obsession with gold and real estate. Hard facts about long-term returns have been published, showing that these assets may not be a good long-term choice. However, investors view such research with skepticism. They continue to prefer physical assets to financial ones, and hold an abnormal amount as cash. Are we mere hoarders of wealth? What does it take to become investors?

First, we are guided by the nominal value of assets. What matters is the real value, after adjusting for inflation, but that is not very intuitive for most investors to perceive. When we are told no one loses money in real estate, we believe it because we have only heard of rising prices. That fact is that with a positive rate of inflation, assets prices move up over time. This is true not just for gold and property, but also for rice, dal, petrol etc. A nominal increase in price does not mean that an asset has become more valuable. As hoarders, we are happy with nominal value; as investors, we will ask about the real value, after inflation.

Second, we like assets even if they do not work for us. Assets are acquired for their ability to earn a return. This should come in the form of a regular  income, such as dividend, interest, rent, or by way of appreciation in value, which we can actually realize when needed. Assets create a sense of security and represent accumulated wealth. They are, therefore, social symbols, which tell the rest of the world that our incomes are far higher, and that we own assets acquired only by the wealthy. Ostentatious display of jewellery and lavishly decorated homes are all social symbols of wealth. When we want to belong to this class, we accumulate assets without caring for the income or the intent to realize gains. We are also reluctant hoarders, unwilling to sell these assets and strip down our social status. As rightly put by ace investor Warren Buffet - "If you buy things you don't need you'll soon sell things you need". As investors, we want the assets to work hard for us and earn returns.

Third, we obsess about the protection of invested capital. The notion is that an asset should have undiminished value dominates our choice. A physical asset, which can be seen and felt, is the obvious choice for the hoarder. Since inflation increases its price, there is a false sense of security about increasing value. The long-term return from assets that do not work cannot be different from the rate of inflation. We see the steadily rising price as hoarders, and expect this from all assets. As investors we know that what goes up will certainly come down and vice-verse. As hoarders, we fail to see the economics of asset prices.

Fourth, we do not understand the dynamics of markets. We prefer an oversimplified version of the way prices should behave since we seek a linear growth in the assets we hold. Assets prices are not influenced only by demand and supply and could also be distorted structurally. The real estate and gold markets in India are dominated by holders of black money. The unaccounted for cash invested in these assets is generated and stored outside the banking system, and is not sensitive to the changes in borrowing costs that the RBI tries to manage. Large-scale tax evasion, ill-gotten bribes and payoffs, and unaccounted for incomes hidden from the taxman feed these assets purchases.

It is a combination of these factors that turns several investors into happy hoarders. When the government says it wants to do something about this preference, it needs to work towards ensuring that the large hoarders and evaders stop distorting these markets. Before blaming the small hoarder, who is unable to make the transition to an investor, we need actual asset builders who will guide. That is the missing link

Saturday, March 30, 2013

Can't Pay Home Loan EMI

Here's how the bank will react to the situation and how you can negotiate with it to resolve it

Buying a house is the most expensive purchase you are likely to make, so you may need help in funding it in the form of loan. What if you take a home loan, but after some time, find yourself unable to ay the EMIs? There could be several reasons for this, from losing your job to depleting your savings for a medical exigency. Will the bank seize your property if you miss 2-3 mortgage payments? No, not immediately, but if you continue to default for six months, the bank will take over your house.

Attaching a property is the last thing a lender wants to do. Though banks have the power to enforce the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, (SARFAESI) to recover non-performing assets without the intervention of a court of law, this is the last step they prefer to take.

A bank usually lets one mortgage payment default slip by, but for the next one, it will mail you a reminder to inform you that your payments are late. After three defaults, the bank will send a demand notice, asking you to pay your dues as soon as possible. If the borrower doesn't respond to any of the mails, the bank sends a legal notice through its legal department.

A bank waits for three months before declaring an asset a non-performing one. After the end of this period, the bank can officially term the home loan an NPA and start the process of recovering the property through the SARFAESI Act.

Even after invoking the Act, the bank gives the borrower a 2-month notice period to repay the dues. Finally, five months after the first default, the bank sends a notice, stating that it has valued the property for a certain sum and that it will auction the house on a particular date. This is usually set for a month from the date that the bank mails you the auction notice.

Banks and financial institutions are more interested in recovering the money than in starting legal proceedings as the procedure of attaching and auctioning a house is lengthy and takes time. So, they will persue the matter for at least six months before taking legal action.

The last state is usually when a borrower gets a notice from the Debt Recovery Tribunal (for loan amounts of more than 10 lakh). It is compulsory for you to attend the hearing that is set by the tribunal, where you can reach an agreement with the bank.

If you are serious about paying your dues and have a good repayment track record, the bank will be willing to offer a leeway. The first step that bank takes is to understand the reason for the default since a home loan is a secured one, with the bank having more control over the asset. If the bank is satisfied that the problem is genuine and that the borrower will start paying the EMI soon, it will be willing to wait for some more time. However, banks take such decisions on a case-to-case basis. In fact, a bank will allow you to reclaim your property even after it has seized it, though this has to be done before the auction takes place. Even if the auction date has been announced, the borrower can come in at any stage and pay the dues to save his property. However, if the bank has incurred any charges for announcing the auction, the borrower will have to pay these.

The main reason you need to start paying the EMI again, other than avoiding possession of your home by the bank, is to ensure that your credit score is not adversely affected. About 30% of your credit score is based on repayment history and a significant part of this usually depends on how regularly you repay your home loan, if you have taken one. Even one or two missed payments can negatively impact your credit score, and a continuous default will dent it severely, making it difficult to get loans or credit cards in the future.

However, if it seems that the situation may not improve even after six months, a better idea may be to sell the property. You can talk to the bank about this and use the sale proceeds to prepay the loan. Ensure that while the sale negotiations are on, you continue paying the EMIs. This will prove to the bank that you aren't taking it for a ride and will ensure that your credit score doesn't dip.

Sunday, February 10, 2013

Rajiv Gandhi Equity Savings Scheme (RGESS)

Who is Eligible?

RGESS is available to all resident individuals whose gross total income is less than 12 lakh and who are investing in equity for the first time. A first-timer has been defined as the one who has not opened a demat account as a 'first holder' before the notification date of 23 November 2012, even if his name appears in a joint demat account opened before this date. The investor who has opened a demat account as first holder before the notification date but has not bought any shares or traded in the futures and options segment will also be considered as a first-time investor.

How can you get tax benefits?

To avail of tax deduction, an investor has to open a new RGESS designated demat account or designate for this purpose his existing demat account, where no trading has taken place before 23 November. He needs to submit a declaration in Form A, certifying that he has not traded before 23 November 2012, to the depository participant, who in turn forwards it to the depository for verifying the status and designate him a new retail investor. He can then start buying the eligible securities, which include stocks from BSE-100 or CNS 100 index. The listed shares of navaratna, maharatna and miniratna pubic-sector undertakings, and initial public offers (IPO) of PSUs, whose turnover is more than 4000 crore, are also eligible for investment. One can avail of tax benefit by investing in the eligible mutual fund schemes too.

What's the lock-in period?

Unlike other tax-saving schemes, the lock-in period here is split in two. The first year is a fixed lock-in and the investor cannot sell, pledge or hypothecate the shares. The next two years are flexible and he can sell, but has to buy other eligible securities with the proceeds. All eligible securities in an RGESS designated account are automatically subject to the lock-in periods. If an investor wants to buy more designated shares and keep these outside the lock-in clause, he has to give a declaration in Form B within a month of the transaction date. The tax benefit under Section 80CCG is withdrawn if these conditions are violated, but if the changes are due to involuntary corporate actions it's not affected.

What are your savings?

While there is no restriction on investment, only 50,000/- is considered for tax purposes. Of this, only 50%, or 25,000/-, is allowed as deduction. Since RGESS is for people with income less that 12 lakh, they will fall in the 10% or 20% tax bracket. The maximum savings under this will be 5000/- for people in the 20% tax bracket and 2500/- for those under 10% (beyond the Section 80C benefits). Besides, the tax deductions will be available for the all the 3 years.

Stocks or mutual funds?

Since direct investment in equity needs expertise and first-time investors are unlikely to have it, they should refrain from investing directly in the market. The risk is also high because 50,000/- is not enough to create a well-diversified portfolio. A better option is to go through the mutual fund route.  Various mutual fund houses have also started filing offer documents for eligible schemes with Sebi, while their new fund offerings (NFO) too are expected soon.