After the recent deregulation of NRE rates – deposit rates for Non Resident Accounts – Karnataka Bank offers 9.75% for the “repatriable” (can take it back) NRE account deposits for a year.

This is awesome, because NRE Account interest is not taxed in India. In the middle east, govt taxes are zero (or very low) so the return is great in the absence of Indian taxes (applicable for other deposits like NRO or for resident accounts).

NRE accounts are in rupees, so the conversion to dollars is at the exchange rate one year later. NRIs can buy a one-year forward rate on the currency which is currently at 55 or so. That is about 6% higher than today so the fully hedged rate, for an NRI, is about 3.75%. But hey, if you believe that the rupee won’t be much worse than today a year from now, the return is very attractive.

(These deposits were at 3-4% earlier. Deregulation has fuelled the rate increase.)

Every week, the RBI conducts auctions selling 91 day T-Bills and in alternate weeks, 182 day and 364 day T-Bills. These are quite short term and is part of the government borrowing. The yields give you an indication of how expensive credit is – remember this is really short term, and then, sovereign debt, meaning it carries the least credit risk for a very short period.

With more than 2 lakh crores is in outstanding T-Bills, and 25,000 cr. in outstanding “Cash-management bills”, all yielding above 8.6%, the credit system is now getting squeezed.

Why should it matter to you? The higher this yield – and the government is the most reliable borrower of rupees – the higher the rates other entities have to pay, like banks, corporates and so on. With the 182-day T-Bill auctioning at higher than the 10 year yield (currently 8.90%), it means the system is very tight about money. Traditionally, such a squeeze has been very bad for corporates and thus, for equity markets.

Reader Tushar writes in, on the “Banks Sucker You On Automatic Renewals” post. He took the trouble of writing to HDFC Bank (thanks!) and getting a response.

We wish to inform that a Fixed deposit is a contract between the Bank and the customer for a given term and at a given interest rate corresponding to the contracted term. Hence, on auto renewal, the term of the contract remains the same and the prevailing rate for that term is offered on the deposit. It could so happen that the Bank's asset liability balance has in the interim changed and hence the rate prevailing for the same term could be higher or lower than the original rate, at the point of auto renewal.

We would further like to clarify that our Bank post November 2006 till January 2009, was offering special rates in the tenures such as 6 months 15 days and 6 months 16 days, 9 months 15 days and 9 months 16 days, 1 year 15 days and 1 year 16 days and 2 year 15 days and 2 year 16 days. However post January 2009, the special rate tenors were changed to only 4 specific tenures i.e. 6 months 16 days, 9 months 16 days, 1 year 16 days and 2 years 16 day and these special rate tenors have since remained constant i.e. the best rates of the Bank have been offered on these tenors only, unlike what has been mentioned in the article referred to by yourself. Customers, who are booking and auto renewing their deposits at these tenors with the bank, have got the better rate on auto renewal.

Perhaps I was mistaken in the “1 year 17 days” option, and I apologize for that if it’s so (I don’t have any proof now).

But obviously people who kept an auto renewal FD before 2006 for 1 year 1 day – which is what most rational people would do – are stiffed. And people who kept it for one year 15 days in 2009 – again, what seemed the logical choice between (1 year 15 days) and (1 year 16 days) – are stiffed. That tiny minority that chose 1 year 16 days is the beneficiary – and in a few years when they figure out they have enough suckers in that tenure…

Colour me cynical, but I don’t trust the banks. Love the stock, love the stability of their offering, love their ATM presence, but this kind of tactic makes me lose faith in their “fiduciary” behaviour (that they will work towards the best for me). You gotta fend for yourself.

Fixed Maturity Plans are being touted as the new way to lock yourself into about 10% yields. But Sandeep Shanbhag mentions why the Direct Tax Code screws the FMP buyer.

FMPs are locked in for a period, the biggest that are being sold now are 370 days or so. That is, you get in now, you get out a year later. Since no one else can get in meanwhile, the fund buys 1 year securities (currently at around 10%) and locks in the interest.

Why is this better than a fixed deposit? FD income is taxed as part of your other income, which could be 30% at the highest slab. FMPs, when held for a year, attract both indexation and Long Term Capital Gains Tax. (Read my post on how LTCG is calculated).

If inflation is 7% and you get a 10% return, your net taxable portion is just 3%, on which 20% is the tax, so you pay just 0.6% of your principal as tax, for a net return of 9.4%. (10% minus 0.6%)

Not any more. The DTC says that for long term capital gains to apply you have to hold for one year after the END of the financial year of investment. Meaning, if you buy today (August 1, 2011), you have to hold the investment till April 1, 2013. (Financial years end on March 31)

Secondly, there's no "20%" tax - the special rate for LTCG expires with the DTC. All long term non-equity gains, post indexation, are added to income.

1 year FMPs will mature after a year; with the new rule, the investment won't qualify under long term holdings. Short term gains cannot be indexed, and are directly added to income. For a one year FMP, you'll earn 10% and all of it will be taxed, which at the highest slab is a tax rate of 30%. You'll earn a net of 7% - exactly the same as a Fixed Deposit.

Equities on the other hand have zero long term cap gains taxes, and the holding period for qualification is one year from the date of investment (not from the end of the financial year like above). Short term gains have better treatment - only half the gains are added to your income.

If you're looking to buy, only consider FMPs that are 20 months or more.

Mutual funds have monthly income plans – MIPs – that provide a monthly dividend; how do these compare against Fixed Deposits (FDs)?

Risk-Free?

First, note that MIPs are not risk free – they invest a little in equities as a “kicker”. So if you’re looking for ultra risk-free return, this is not it. I’m just looking at it as something that a retiree or semi-retiree can invest in, and doesn’t mind the slight additional equity risk. A lot of people I know would qualify.

Example

Let’s take a 25 lakh investment made in an MIP – HDFC’s Long Term MIP Monthly Dividend plan is what I chose. Compare it with the same amount invested in a Fixed Deposit (FD) yielding 9% (Okay, no one gives 9% a year on FD monthly income, but let me be aggressive).

Taxation: Dividends on MIPs are tax-free; FD Interest is taxable. I’ve assumed a 20% tax. (Note, however, that about 13.6% of dividend distribution tax applies to mutual funds , including surcharge and cess, but this is paid by the mutual fund, not you. It reflects in the NAV.

Nowadays banks deduct 10-20% tax at source for FD interest – so if you get a lower tax rate you have to ask for a refund. That is crazy for someone who’s investing for a monthly income!

Returns: I plotted the four-year graph (assumed started on Jan 1,2007) of the entire return. The line graphs are the return-to-date for MIP and FD (including interest/dividend post tax) and the bars are the monthly income levels.

The return (blue and red lines) are the simple interest on the FD - since we require income, I assume no reinvestment of either the dividend or the FD interest.

The purple and green bars are the cash-flows every month.

Cash flows: The FD interest is constant, as expected (a net yield of 7.2%). The Monthly Income Plan has wayward income but you see the equity kicker give spiky income, but they seem to cap themselves at the lower end to what FDs would give.

The FD income, post tax, is about 15,000 per month, while the MIP dividend which is tax-free anyhow, is about 13,000 per month. However the difference is more than made up by the huge change in

MIPs seem to generate slightly higher income in parts – sorta like getting a bonus every once in a while.

Verdict?

The MIP has done well in the last four years - an effective yield of 7.70% versus 7.02% for the FD (this is assuming interest and dividends were not reinvested).

But the last one year has seen a flattening down, because the equity markets haven't done too well and the long term debt market's suffered on account of rising interest rates. Also FD rates are up to 10% now and interest rate slabs have been rejigged so your eventual tax liability with a 25 lakh deposit should be at 10% - that brings the FD return much closer to the MIP.

Liquidity wise: both the FD and MIP are liquid (you can get money out in a few days). The FD carries a penalty for early withdrawals though, and the HDFC MIP has a 1% exit load for the first year.

On the face of it, with the higher risk, the MIP seems like a useful option for someone with a large corpus and wants a higher monthly income. And lesser tax reporting hassles or refund issues.

Considering tightening liquidity in the markets and the fact that I expect equity markets to hurt with rising rates, I would expect the FD to outperform the MIP but only if you are in low interest rate slabs and looking primarily for income. If you are in a higher tax slab, then a short term debt fund is likely to do better (even a short term MIP) If you're okay with keeping your money in for a year and then manually withdrawing money for cash flow each month, you could choose a growth plan and make higher returns because you don't get that 13% dividend distribution tax hit.

Finally, if you're already invested, moving to a different plan has a cost, that the new instrument will have a lock-in, work that out in your calculations before you move.

Note: Other options – tax free bonds that yield around 6.5% to 7.5%, Government 10 year bonds that yield a taxable 7.5% or corporate 10 year debentures that yield 10% or so. Some of these have monthly options too; and may be even better.

This post is written by Deepak Shenoy, at Capital Mind.

(Legend - size of the circles is the total amount traded, X axis is days to maturity , and Y Axis is the yield in % to maturity, annualized)

CD trades are short term (<365 days) and are quoted as discount to maturity (there is no coupon interest rate). So you buy at 99.5 and get back Rs. 100 in N days.

Importantly, the last few days have been been seeing heavy and high yield trades at the low end of the game - look at the top left, there are a number of trades above 11.5% in the <20 day range.

People are willing to pay more (and therefore get less yield) from a 1 year CD, where yields are around 10%, than for a 15 day deposit where it's 11%+. In general that would mean an inverted yield curve (basically lack of near term money, but people expect that in the long term, rates will come down). That situation has been a negative for equities the world over, and while it hasn't yet shown up in bonds (where the yield curve is between the 1 years and the 20 year bonds) the CD market is showing signs of stress. It could be a March 31 effect, since strange things happen near the end of a financial year.Or it could be more deep and systemic - we'll see in the first week of April. In my view it should ease up in April, but my view is not important.

This post is written by Deepak Shenoy, at Capital Mind.

(Posted in entirety)

"Inflation rears its ugly head again, as RBI prepares to raise interest rates." You hear this all the time, and then wonder why you should bother. Over a year now, we, the retail public have been getting horrendously low deposit rates from banks. And if we got a bank offering us 9% deposit rates, the interest was taxed; and at the highest bracket, our real return was only 6.3%.

But this sounds incongruous with what the papers are telling us — that liquidity is tight, or that banks want money. If they are, why aren't we getting better deposit rates?

I have an emergency fund — 6 to 12 months of expenses — in a safe avenue, but I don't know if this emergency will happen in 1 month or after 5 years. My putting the money in a fixed deposit yields very little; plus, I end up paying tax on the interest. And if I use a longer term deposit, I get hit by a pre-closure penalty if I should have an emergency in the meantime.

So we've got three issues — we don't get the best interest rates, we pay taxes on the interest even if we reinvest it, and we fear pre-closure penalties. Is there a way around this, retaining the same safety as a fixed deposit?

Enter the debt mutual fund. Mutual funds are assumed to have equity exposure, but that is a fallacy; in India, more than 80% of mutual fund assets are in non-equity investments, mostly fixed income products. These invest in markets where money is traded, like call money markets, fixed income derivatives, bond markets; here, what you would get for a 1-year investment with the same bank is likely to be higher than what the bank offers for retail deposits.

For example, on Tuesday (18 Jan), an HDFC bank "Certificate of Deposit" (CD) was available at an interest of 9.74% for one year (You can see what was traded at http://www.fimmda.org) The best HDFC Bank Deposit for a one year term is 8.25% - so the difference is substantial. You and I can't participate directly in these markets — plus, ticket sizes are 1 crore or more.  The way to get in is to invest through a debt mutual fund; in this case, "ultra short term" or "floating rate" funds. They buy these CDs, charge a management fee of the order of 0.5%, and give you the rest.

When rates go up, these funds rotate money often, investing in short term instruments (sometimes as short as one day), and take advantage of the rate increases as they happen.

But then, you ask, what about taxes? In mutual funds, you don't get taxed on any intermediate gains until you decide to sell. Keep the money in for two years? The fund may rack up gains, you don't pay tax. And if you decide to sell after a year, you get the additional benefit of long term capital gains tax, which I'll illustrate with an example.

Let's say you put in 500,000 into such a fund, exit after a year, and get a 9% return. That's Rs. 45,000 of gains. With long term capital gains, you get to "index" the gains; that means, they let you adjust the principal up for inflation. The 500,000 that you invested will be considered as 530,000 (assuming 6% is the announced inflation). Your taxable gain is only 15,000 — and the tax on that is, at 20% currently, just Rs. 3,000.

Compare that with making 45,000 in a fixed deposit — it will be added to your income and taxed; at the highest tax slab, you pay 30% of it, or Rs. 13,500 in taxes.

Now, consider the real world. It's hardly likely you would need the entire 500,000 you have stored for a rainy day. You might need Rs. 50,000 for an operation, or Rs. 100,000 to cover an emergency, but not the full amount. With a mutual fund, you can draw only a little bit at a time, without a penalty — and while certain fixed deposits do allow you early partial exits through a "sweep-in" facility, but most banks have started to charge a penalty for early exits.

Finally, funds are just as flexible. Nowadays you can buy and sell online, through the fund's website, your bank or your brokerage account. Money gets directly credited into your account, so it's just as hassle-free as a fixed deposit.

And of course, there are negatives. Today, we have a rising interest rate situation. When rates start to come down, floating rate funds are not the place to be.

We have a "flat" yield curve; at the shorter end (1 year or less to maturity) interest rates are very high — from 7.4% to 10%, with even 20 year debt sticking in the 8.5% to 10% ranges. If the curve "steepens", or short term debt becomes substantially cheaper compared to the longer term, then these floating rate products will likely give lower returns. But with RBI looking to hike up rates (RBI can only change short term rates at the moment) it's unlikely we see a steepening event that will hurt us — at least, in the one year term that people usually consider for fixed deposits.

Additionally, the risk in mutual funds is that they can choose to invest where they want; what if they buy dodgy instruments? These funds reveal their portfolio monthly, but you'll still need to check and see if they are buying rotten apples.

And the last risk is that rates aren't guaranteed, like you see with fixed deposits. They move according to the market prices. We love our sticker prices, and we love our guaranteed rates. But the risks seem benign; it's time to look at products that don't keep adding to our tax bill unnecessarily, and give us both flexibility and competitive returns.

More Yahoo Columns:

• Market Interventions (Comments)
• ULIPs or Mutual Funds? (Comments)
• Taking Stock of Commissions (Comments)
• Innovations and Curses (Comments)
• Free Money (Comments)
• The Illusion of Low Risk (Comments)
• Tips about the Tipsters (Comments)
• The Good, Bad and Ugly of Credit Cards (Comments)
• The Problem with Multi-Level Marketing (Comments)
• Planning for the Grim Reaper (Comments)
• Of Options and Choices (Comments)
• Riding the Equity Wave (Comments)
• The Art of Picking Stocks (Comments)
• (The Whole Lot)

This post is written by Deepak Shenoy, at Capital Mind.

The finance ministry on Monday approved issue of bonds by railways worth Rs 5,000 crore for the financial year ending March 31, 2010.

The bonds will be issued by Indian Railway Finance Corporation (IRFC), which will be tax-free, secured, redeemable and non-convertible, carrying an interest rate in the range of 6.5% to 7.25% per annum. The bonds will be available in the form of public issue.

Hat Tip: @b50

I couldn’t find any information on the IRFC site though their earlier bond issues are listed, at 4 to 8.5%.

Risk: IRFC is not explicitly guaranteed, though a risk transfer agreement shifts capital raising requirements to the Ministry of Railways. Technically that could still mean a risk (unless you hear “explicit guarantee”, there isn’t one). But it is less risky than bank deposits, for sure.

A tax-free rate of 7.25% is greater than 10% pre-tax; this is the equivalent of a 10% fixed deposit, but your money is locked for 10 years or so. 

This post is written by Deepak Shenoy, at Capital Mind.