Wednesday, April 22, 2009

Common Financial Terms - Part III


r-squared

A measurement of how closely a portfolio's performance correlates with the performance of a benchmark index, such as the S&P 500, and thus a measurement of what portion of its performance can be explained by the performance of the overall market or index. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation.

back-to-back loans

An arrangement in which two companies in different countries borrow each other's currency for a given period of time, in order reduce foreign exchange risk for both of them. also called parallel loans.

Authorized shares

The maximum number of shares of stock that a company can issue. This number is specified initially in the company's charter, but it can be changed with shareholder approval. Generally a much greater number of shares are authorized than required, to give the company flexibility to issue more stock as needed. also called authorized stock or shares authorized.

Swap spread

The difference between the swap rate on a contract and the yield on a government bond of the same maturity. It is used to represent the risk associated with the investment, since changes in interest rates will ultimately affect return. Swap spreads are based on LIBOR rates, the creditworthiness of the swap's parties, and other economic factors that could influence the terms of the investment's interest rates.

Variable rate

Any interest rate or dividend that changes on a periodic basis. Variable rates are often used for convertibles, mortgages, and certain other kinds of loans. The change is usually tied to movement of an outside indicator, such as the prime interest rate. Movement above or below certain levels is often prevented by a predetermined floor and ceiling for a given rate. also called adjustable rate.

Payout

A taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earnings, usually quarterly. Payouts are usually given as cash (cash dividend), but they can also take the form of stock (stock dividend) or other property. Payouts provide an incentive to own stock in stable companies even if they are not experiencing much growth. Companies are not required to pay payouts. The companies that offer payouts are most often companies that have progressed beyond the growth phase, and no longer benefit sufficiently by reinvesting their profits, so they usually choose to pay them out to their shareholders. also called dividend.

Employee Stock Ownership Plan

ESOP. A trust established by a corporate which acts as a tax-qualified, defined-contribution retirement plan by making the corporation's employees partial owners. contributions are made by the sponsoring employer, and can grow tax-deferred, just as with an IRA or 401(k) plan. But unlike other retirement plans, the contributions must be invested in the company's stock. The benefits for the company include increased cash flow, tax savings, and increased productivity from highly motivated workers. The main benefit for the employees is the ability to share in the company's success. Due to the tax benefits, the administration of ESOPs is regulated, and numerous restrictions apply. also called stock purchase plan.

Preferred shares

Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preferred shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred share pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred share is that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. also called preferred stock.

GDR

Global Depositary Receipt. A negotiable certificate held in the bank of one country representing a specific number of shares of a stock traded on an exchange of another country. American Depositary Receipts make it easier for individuals to invest in foreign companies, due to the widespread availability of price information, lower transaction costs, and timely dividend distributions. also called European Depositary Receipt.

Incentive stock option

ISO. A type of employee stock option which provides tax advantages for the employer that a non-qualified stock option does not, but which is subject to more stringent requirements. For ISOs, no income tax is due when the options are granted or when they're exercised. Instead, the tax is deferred until the holder sells the stock, at which time he/she is taxed for his/her entire gain. As long the sale is at least two years after the options were granted and at least one year after they were exercised, they'll be taxed at the lower, long-term capital gains rate; otherwise, the sale is considered a "disqualifying disposition", and they'll be taxed as if they were nonqualified options (the gain at exercise is taxed as ordinary income, and any subsequent appreciation is taxed as capital gains). ISOs may not be granted at a discount to the current stock price, and they are not transferable, except through a will. also called qualified stock option.




Financial Terms - Part I
Financial Terms - Part II
Financial Terms - Part IV
Financial Terms - Part V
Financial Terms - Part VI

Tuesday, April 14, 2009

Post office Recurring Deposit

What is Post office Recurring Deposit Account (RDA)?

A Post-Office Recurring Deposit Account (RDA) is a banking service offered by Department of post, Government of India at all post office counters in the country. The scheme is meant for investors who want to deposit a fixed amount every month, in order to get a lump sum after five years. The scheme, a systematic way for long term savings, is one of the best investment option for the low income groups.

Features

The minimum investment in a post-office RDA is Rs 10 and then in multiples of Rs. 5/- for a period of 5 years. There is no prescribed upper limit on your investment.

The deposit shall be paid as monthly installments and each subsequent monthly installment shall be made before the end of the calendar month and shall be equal to the first deposit. In case of default in payment, a default fee is chargeable for delayed deposit at 0.20 Paise per month of delay, for Rs.10 Denomination. After more than four defaults, the account shall be treated as discontinued in case the account is not revived within two months from the fifth default.

For Advance deposits for 6 months or 12 months, a rebate is allowed at the prescribed rate (For Rs 10 denomination:- Rs.1/- for 6 advance deposits, Rs.4/- for 12 advance deposits.

One withdrawal is allowed after one year of opening a post-office RDA on meeting certain conditions. You can withdraw up to half the balance lying to your credit at an interest charged at 15%. The withdrawal or the loan may be repaid in one lump or in equal monthly installments.

Premature closure is allowed on completion of three years from the date of opening and in such case, interest is payable as per the rate applicable for the Post Office Savings Bank Account.

After maturity of the account, it can be continued for a further period of 5 years with or without further deposits. During this extended period, the account can be closed at any time.

Returns
The post-office recurring deposits offers a fixed rate of interest, currently at 7.5 per cent per anum compounded quarterly.














































Monthly Investment Total Investment(60months) Money returned on Maturity (after 60 months)
10 600 728.90
20 1200 1457.80
50 3000 3644.50
100 6000 7289
500 30000 36445
1000 60000 72890
1375 82500 100224
5000 300000 364450


Advantages
The post office offers a fixed rate of interest unlike banks which constantly change their recurring deposit interest rates depending on their demand supply position. As the post office is a department of the government of India, it is a safe investment. The principal amount in the Recurring Deposit Account is assured. Moreover Interest earned on this account is exempted from tax as per Section 80L of Income Tax Act.

How to Start Post office RDA
A post-office RDA can be opened at any post office in the country by filling up the appropriate forms. The account can be opened by an individual adult as a single person account, two adults in a joint mode, or by a guardian on behalf of the minor who has attained the age of 10 years in his own name. A pass book is issued at the time of opening the account. If there is a loss, theft or the passbook is mutilated, a duplicate is issued on a charge. The deposit can be made personally at the particular post office every month or can be made through an appointed agent, who would collect the money from you and enter the same in your passbook.

Sunday, April 5, 2009

Types of Equity Mutual Funds

We all know what a mutual fund is. A Mutual fund is nothing but a common pool of money collected from investors and managed by a fund manager who would buy/sell stocks on our behalf and share the profit/loss with us. To know more about mutual funds click here

If somebody is talking about mutual funds, almost always they talk about equity mutual funds.

What is an Equity Mutual Fund?

A MF scheme that invests at least 65% of its fund corpus into equity and equity related instruments is called an equity mutual fund. Equity funds carry the most risk among all kinds of MFs because they invest in the stock market. This risk comes with the potential of high returns.

Types of Equity mutual funds:

Based on the investing style equity mutual funds are broadly classified into 4 categories:

  1. Equity Diversified funds
  2. Equity Linked Saving Schemes (ELSS)
  3. Index funds & ETFs
  4. Sectoral Funds

Equity Diversified Funds:

These are actively managed funds that invest across stocks and sectors. They do not concentrate on only a few sectors or scrips but focus on either large-caps or mid and small caps. They could also be thematic, for instance funds focusing on rural growth or infrastructure. These funds are riskier than index funds because their performance depends on the fund managers abilities to buy and sell the right stocks at the right time.

The top 3 Equity diversified funds are:

  1. ICICI Prudential Infrastructure fund
  2. Reliance RSF – Equity
  3. UTI dividend yield fund

ELSS funds:

ELSS are also diversified equity funds but offer income tax deduction under sec 80C up to a limit of Rs. 1 lakh. It also imposes a three year lock in period. You cannot redeem your units before the end of 3 years.

The top 3 ELSS funds are:

  1. Sundaram BNP Paribas tax saver
  2. SBI Magnum Tax gain
  3. Fidelity Tax Advantage

Index Funds:

These are the simplest and least risky of all equity funds. They invest in all the scrips and in exactly the same proportion as the scrips lie in their underlying benchmark indices. While an index fund buys and sells scrips on the stock exchanges, an ETF (Exchange Traded Fund) appoints market participants. They exchange a basket of securities (whose composition exactly matches that of the benchmark index) against an ETF unit. These ETF units are then traded on stock exchanges like stocks.

While index funds can be bought or sold from the MF or through an agent like any other ordinary scheme, ETFs can only be bought and sold on exchanges, therefore you need a DEMAT account to buy/sell them.

Sectoral Funds:

These are the riskiest of all funds. They invest in a single or at best two or three closely linked sectors. Their fortunes depend on these select sectors & its stocks only. As their name indicates, the fund house buys/sells stocks only in the sector on which it declared to invest while offering the fund. If the sector that the fund house invests performs well then our returns would be more than a equity diversified fund or an index fund but at the same time, if a sector underperforms our returns would get affected adversely. These funds are not for the normal investor. It is only for high risk and knowledgeable investors who can actively track their portfolio and exit a sector before it is adversely affected.

Note: This is not a recommendation to buy the mutual funds mentioned in their respective categories. This is just an illustration to point out the best funds in the categories as per my view as of today April 5th 2009. The funds performance may change its ranking over the next few weeks/months/years.


Happy Investing!!!

Saturday, April 4, 2009

Investing in Corporate Bonds



The bond market is currently abuzz with scores of investors investing money in millions in it. Before getting into the details let us first find out what a corporate bond is.

A corporate bond is something similar to a bank fixed deposit. The company issuing the bond accepts your deposit and issues you a certificate as proof of your deposit. During the deposit the company agrees to pay you an interest for your deposit. You can opt for periodic interest payments or one lumpsum payment at maturity. All said and done, there are a few major differences here.

1. The interest offered by corporate bonds are higher than that offered by banks
2. There is no guarantee that you would get your money back. The bond is issued on a best effort basis where the company would try its best to repay your money along with interest provided it is able to make sufficient profit.

Now you know why corporations offer a higher interest rate “To attract investors who are ready to take the risk by offering a higher Return on Investment (RoI)

Why are Corporate Bonds so attractive now?

With the ongoing financial crisis, the equity markets have slumped to nearly half of its peak value at the beginning of the year 2008. Most investors have lost interest/faith in the stock markets and are considering other avenues of investment which can provide them better returns. Currently bonds are one among the top investment options because they offer a better RoI than bank deposits. Though they come with an inherent risk, most corporations that issue bonds are in pretty sound financial status and the chances of losing our principal is comparatively low. Since bonds are like bank deposits your capital remains intact and hence bonds have become attractive now.

The bonds that are currently being issued offer us returns of around 11% which is nearly 2-3% more than what banks offer us.

Though the returns on corporate bonds are high, they come with their inherent risks. Below are some aspects that you need to check before investing your hard earned money in them.

Creditworthiness

Default in payment by the bond issuer is one f the major risks that we face while investing in bonds. The default could range from untimely payment of coupons to non payment of principal at maturity.

The chances of default can be found out by the rating assigned to the bond by authorized agencies on the basis of a rating scale. The higher end of the scale indicates better credit quality which means that the chances of default are lesser. Apart from the chances of default, such agencies also consider another risk before assigning a rating. That is the sector specific risk. If an industry is going through a rough patch due to the prevailing economic scenarios then the chances of the company performing well are lesser. Hence this would naturally affect the company’s finances and eventually affect the bond rating.

It is a general thumb rule to choose bonds with good credit ratings over the ones with not so good ratings.

Risk Return Balance

We should analyze our risk appetite before investing in certain bonds. Some company’s offer very high returns but their credit history wouldn’t be so great. Investing in such bonds should be done with caution.

We can compare the returns on existing bonds with a similar rating in the market to find out the kind of returns that we can expect in new issues. But the yield on a particular bond would also depend on the industry in which the bond issuing company operates. For example the yield on an ‘AAA’ bond in a finance industry would be higher than that of an ‘AAA’ bond in a manufacturing industry. But at the same time, investors would prefer manufacturing industry because of the safety of investment and would prefer them over finance bonds.

We must analyze the performance of the issuing company before making our investment.

Exit Options

One of the most important considerations before buying a bond is the liquidity offered. This is important because most bonds are long term investment options wherein your money would get locked in for 5 – 10 years.

Premature selling of bonds would expose us to interest rate risks. For example, when interest rates go up, new bonds start offering higher rates than that of existing bonds. So at such a situation if you want to sell your bond, you would have to sell it for a lower price than what is its current market value.

Also, some corporations may not be able to pay off the bonds if we plan to exit before maturity. Though these securities are listed in registered exchanges, they may not be liquid and you may not be able to sell them at the current market value. You may have to compromise on the selling price while selling such illiquid securities.

Other factors

Some other factors to be considered before buying such bonds are:

  • Do not invest in complex bonds. The simpler they are the better they are for you. For example some bonds give us the option of converting them to that company’s shares. This increases the volatility in price of the bond and it is better to stay away from them.
  • Industry situation: Always some industries would outperform its peers and some may underperform. Investing in bonds from industries that are struggling would adversely affect both liquidity and returns on our investments.
  • Credibility & Integrity of the Rating agency. Do not just go by the rating given by the rating agency. Analyze the credibility and past history of the agency before believing their rating. Also remember that these ratings are only speculations and do not guarantee the bond performance.


Happy Investing!!!
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