Tuesday, November 27, 2012

It's time to invest in Bond Funds

Income funds—also known as bond funds—are subject of intense discussion today. There are two schools of thought on justification of investing in bond funds—with both sides presenting their line of thinking. Issues like high persistent inflation, interest rates, lack of industrial activity and upcoming general elections in 2014 unnerve the most informed investor today from writing out the cheque for bond funds today.

Here below we make a humble attempt to make out a case for bond funds.

Any market is basically a function of demand and supply. Prices rise if demand outstrips supply and vice versa. It has been observed over last couple of years that 10Yr G-Sec yields peaked between November—December and then rallied till February –March of the next year. This phenomenon played itself out as recently as in 2011, when 10Yr G-Sec yields peaked at 9% in mid-November and then rallied till 8.15% by February. This action unfolded without any rate cuts though which is noteworthy.

RBI usually steps up its OMO (Open Market Operations) towards the latter part of the financial year in order to cope with liquidity crunch in the system owing to seasonal leakages during the festive season.

OMOs are nothing but RBI buying Government bonds and thereby infusing liquidity into the market.

Having said as above, we believe the odds are presently in favour of a rally in bond market—rate cuts or no rate cuts—as in last 2 financial years.  A rate cut will be icing on the cake.

A look at the demand supply dynamics in the G-Sec segment:-

After the auctions scheduled for this week, the gross supply left is roughly Rs. 1, 09,000 crores. The demand may come in from the following categories:-

1.       Reserve Bank of IndiaDemand of Rs. 60,000 crores

Market expects a minimum of Rs. 60000 crores of G-Secs to be mopped up by RBI through OMO (Open Market Operation). Presently the liquidity deficit in the Indian market is expected to be around Rs. 1, 15,000 crores, owing to seasonal factors. This is far in excess of the comfort zone of RBI at Rs. 70,000 crores. (The comfort zone is 1% of NDTL which is Rs. 7 lac crores). NDTL stands for Net Demand and Time Liabilities.

2.       FIIsDemand of INR 15,000 crores

Indian Government is expected to increase the FII limit in G-Secs and corporate bonds by another $5 billion each. FM has expressed his desire for INR to appreciate. Subsequent to his assuming office and backed by flurry of “reform” measures announced thereafter saw INR rally to Rs. 51.80 levels in early October2011 levels from INR57.25 in June 2011, falling

to INR 55 levels thereafter. It is therefore reasonable to expect Government to step up efforts to attract capital flows to stem the slide of INR. Hence, we can conservatively estimate a G-Sec demand of Rs. 10-15000 crores coming from FIIs.    

3.       BanksDemand of Rs. 40,000 crores

The current deposit growth by banks is 13-14%. If they end the year maintaining this growth rate then they have to mobilize Rs. 2, 50,000 crores of deposits till 31/03/2013. Even if they buy 25% of these into SLR, it generates an additional SLR demand of Rs. 60,000 crores. Of this, even if we assume they buy G-Secs worth 2/3rd of this incremental demand, there’s a demand of Rs. 40,000 crores

The total demand as listed above adds up to Rs. 1, 15,000 crores against a supply of only Rs. 1, 09,000 crores.—enough to exhaust the entire supply of government papers.

Further, likely demand from insurance sector, provident funds, and mutual funds have not been considered in the above—which will only further increase the demand. The analysis holds even if additional liquidity leakage of Rs. 20-30000 crores happens till 31/03/2013.
Given the above, it is clear that while rate cuts may be required to sustain a bond rally in the time ahead, they are definitely not needed to get the rally started from here on. The supply, or the lack of it, alone is enough to start the rally from here; and in the very foreseeable future. If investors believe the logic given above, then those still on the sidelines have every reason not to continue to wait any further.

The views expressed above are personal views of the author. This article is based on information already present in public domain. Neither the author, nor his firm nor any of his representatives shall be held responsible for any damages, whether direct or indirect, incidental, special or consequential including lost profits or lost revenue that may arise from or in connection with the use of the information. 

Thursday, November 22, 2012

Child's Education--Delay will be Very Costly

It is human nature that we strive to meet immediate financial needs and postpone the one which are still some years away. Impact of postponing a future need—how so ever important—will ultimately prove to be expensive/costly—both financially and psychologically—is something we do not give a second thought to.
When the day of reckoning arrives—we blame everybody but ourselves. For example, milestones like children’s education or our own retirement are events we do not seriously think about as they are future needs. The fact that you should think about retirement as soon as you start working is more often than not given a miss. “It’s too early to think about retirement” is the most common phrase we hear when we talk about retirement to our clients.  Most people start looking for funding when their children are very close to their higher studies. The hard truth is that you don’t have much choice when it comes to your child’s education. No parent in this world likes to compromise on their children education—and if they follow a disciplined approach to building a corpus, they need not compromise. In absence of shortfall in funding, the difference is usually made by transferring funds from the retirement corpus (PF/EPF Gratuity etc.)

Even if you postpone the planning for your child’s education by 5 years, then be ready to shell out double the amount to accumulate the desired corpus within a definite time frame. Consider this:-

·     If you have 15 years to plan for your child’s future, you should save Rs. 57,000 a year or Rs. 4,800 a month.
·     If you have 10 years in hand, you need to save Rs. 1.20 lacs (Rs. 10,000 per month) to accumulate the same corpus.
·     However, if you have only 5 years to accumulate the desired corpus, then be prepared  to shell out Rs. 3.35 lacs a year(Rs. 28,000 per month) (See table below)

Time to goal
Asset Allocation
D/E Ratio
Expected Returns
Annual Savings (Rs)
Child 1
Rs. 20 lacs
5 years
Bond Fund/Large Cap Equity
Child 1
Rs. 20 lacs
10 years
Bond Fund/Large Cap Equity
Child 1
Rs. 20 lacs
15 years
Bond Fund/Large Cap Equity

Less time on hand implies that you cannot take risk and hence you have to invest in securities which are safe and thereby compromising on returns. (Read Virtues of Long Term)

Less time also restricts the choice of options available to plan for desired corpus for a milestone as important as your child’s education.

Asset allocation plays a very important role in any investment strategy. The success or failure of an investment strategy depends on the asset allocation one adopts. It is often said that a successful investment strategy is 10% timing and 90% proper asset allocation.
If the asset allocation is skewed in favour of fixed interest securities (bank FDs etc.), chances are that you will fall short of target corpus (since inflation nibbles away a part of your meager returns). If however, the asset allocation is biased towards equity, then a crash in equity markets near to your deadline mazy force you to postpone your encashment or make good the shortfall from other sources.

For the purpose of calculations, we have assumed that bond funds will return 8%CAGR (net of tax), while equity funds will return 12% CAGR (net of tax).  For the debt portion, we advise bond funds as they give better tax adjusted returns as compared to other fixed interest securities. (Debt funds have the benefit of indexation benefit if held over a year).

The debt to equity ratio of 80:20 for 5 year time horizon should be changed in favour of equities to 35:65 or 20:80 as over long term, equities always delivers superb returns.

Parents have an affinity to buy insurance policy for children under the impression of securing their future. Insurance plans have an embedded cost structure which will reduce the overall returns. On the other hand mutual funds (both debt and equity) are better placed to offer market linked returns, with far lower costs in built into them. We at AIMS, have always favoured either surrendering your child insurance plans or make them paid up after consulting your financial planner.

Either make an informed decision yourself, or call on us to assist you in arriving at one---today

Tuesday, November 13, 2012

Why avoid Endowment Plans

Recently the writer was approached by a SDM of an insurance company with a proposal to take up agency of their company and sell insurance policies. Traditional plans was to be the focused upon. With ULIPs losing their appeal (since with cap on costs, the commission has also been reduced), traditional plans are being pitched aggressively..

Traditional plans are back in vogue. Not because they help the investors meet their long term goals, but because it pays big commissions to the agent. A traditional plan currently pays nearly 30% of the first year’s premium as commission apart from other emoluments to the insurance agent. It’s time the investor ask themselves:- Does endowment policies serve any purpose? If not are there any alternatives? Let’s try to find out.

Let’s take a hypothetical example of Anuj who is a 30 year old male—who wants to build a retirement corpus when he turns 60. His Endowment policy would look as under:-

Tenure                                                 30 years
Sum Assured                                      10 lacs
Annual Premium                                 Rs. 30,723(including Service Tax)
Maturity amount                                  Rs. 21.46 lacs(at 6%)       

The following conclusions can be drawn from the above information:-

Annual Premium outflow                     Rs. 30,723/-
Premium payment term                      30 years
Death claim payable                           Rs. 10 lacs
Likely maturity amount                   Rs. 21.46 lacs (plus loyalty bonus if any)

Let’s calculate the interest earned on this payment. Rs. 30723 paid for 30 years becomes Rs.21.46 lacs

The formula for Rate is (nper,pmt,pv,[fv],[type) where
                                                                Nper is the period of payment
                                                                Pmt is payment per period
                                                                Pv is the present value of the payment
                                                                FV is the future value receivable
                                                     Type is payment at beginning or end of period

Substituting the values in the equation for Rate= (30, -30723,0,2146000,0),R is calculated to be 5.3%. Is this rate good enough to justify your hard earned money? We believe the only reason people buy endowment plan is for compulsory savings that such plan tends to demand of them. Insurance cover is a bye product that they get—which any how is minuscule and irrelevant. It also gives the investor a mental satisfaction that they have done financial planning (?) for their family.
The basic premise of an endowment policy is insurance+returns. So let’s try to work out a combination ourselves which will be better than the endowment and yet costs less.

A.     For a Highly conservative Investor

Term Assurance for Rs. 30 lacs for 30 years---Rs. 8676/- per year.(incl. service tax)
 Invest Rs. 22000 per year in PPF for 30 years--- Rs. 26.90 lacs.
 Amount Invested: -   Rs. 30676 per year (8676+22000)      
             Death Benefit       : - Rs. 30 lacs+PPF
             Maturity Benefit: -  Rs.26.90 lacs (PPF maturity)

B.      For An Aggressive Investor

Term Assurance                               Rs. 50 lacs—Rs. 12600/- p.a.
Investment in MF through SIP: - Rs. (30000-12600) -- Rs.17400/-               
(returns assumed 15% CAGR)

Death Benefit                    Rs. 50 lacs+Mkt value of investment.
Maturity Benefit              Rs. 1.05 crores (Mutual Fund maturity) 

Hence, it is advisable for people who have taken an endowment policy to convert it to a paid up policy and divert the current premium in one of the options as above (depending upon your risk profile). However, if the term of the endowment policy is nearing maturity, then let it run to maturity.

Insurance is supposed to replace your income in your absence. It is not supposed to supplement it. Insurance is not designed to generate returns, but manage risk. There are other products for investments. People are advised not to get lured by the fancy features of the policies and exotic excel illustrations. Judge the policy by your requirements and not that of the agent’s.

Disclaimer:- The figures used above are for illustration only. The exact figure may differ from those above. Premium figures are that of HDFC Standard Life Insurance Co. Ltd.
Views expressed are personal views of the writer. Investors should use their own judgment and discretion while evaluating their requirements. It is advisable to appoint a certified planner for impartial professional advice.