Why I don't like REC Tax Free Bond Issue

Today is the last day for subscription for the REC's (Rural Electrification Corporation) tax free bonds - which many analysts have recommended as a good investment option. I disagree to the basis of the recommendation which seems to be just the tax angle.  Only naïve fixed income investors use Fixed Deposit as investments and hence the rest of the post assumes this extent of sophistication.

Most analysts who recommend the tax-free REC bond issue convert the coupon of the bond to a pre-tax yield adjusting for the tax bracket (taking the highest tax bracket of 30%) making the 7.88% p.a. yield to 11.26% (=7.88%/(1-0.30)) and claim it is higher than the pre-tax yield of most other fixed income instruments.  The tax adjustment rate used in the calculation above should be the tax rate that makes the "Tax-free" bond yield comparable to "Normal" bonds in the market and not simply the tax slab of the individual/company.  Fixed income instruments are taxed at 10% without indexation or 20% with indexation - which makes the recommendation of the analysts totally flawed.

If the long term taxation rules of Fixed income instruments are to be observed (Link) they are either 20% with indexation or 10% without indexation.  This practically puts a cap on the potential upward revision of the pre-tax yield of the "tax-free" bond to 1/(1-0.10) and not 1/(1-0.30) - using this base case the pre-tax yield of the REC bond for 15 year turns out to be 8.76% (=7.88%/(1-0.10)). This is not screamingly higher than the other available instruments available in the market.  Just to give a sense, SBI Dynamic Bond Fund (Link) has an average YTM of 8.60% and average maturity of 11 years; no comments on the liquidity angle where the mutual fund route is definitely more liquid. There are other bond funds with longer duration and equivalent credit quality.

If the indexation angle is taken into consideration, (data here), the indexation benefit for the last 1, 5, 10 and 15 years are 8.5%, 10.92%, 9.06% and 10.49% per annum respectively. This practically means the interest income from fixed income instruments after adjusting for the indexation benefit, there is hardly any income and hence hardly any tax payable.  There could be instances of tax credits in some of the years.  It is to be noted even in the Direct Tax Code, the indexation benefits are likely to remain intact. Hence after the indexation angle, I do not see any advantage of subscribing to the REC bond vis-a-vis the fixed income instruments available through the Mutual fund route.

The main risk to my recommendation is that the fund manager drastically changes the duration/credit profile. Having said that, the bond funds have the diversification benefit.

Bottomline: REC Tax-free bond is inferior to other available fixed income investment routes with respect to the net tax free yield at the hands of the investor.

Update: Market seems to echo a similar sentiment as mine with respect to these Tax Free Bonds (TFBs). Here is a Business Standard report of why TFBs have been disappointing this year.

Optionality of Cash

A blog post after some time: Optionality of Cash

Sustainability of GDP

Oftentimes it is considered that a growing GDP is a panacea. We (at least yours truly) have believed that an increased Government spending and investment in infrastructure will ‘always’ lead to growth in GDP and hence it contributes towards the panacea for all economic frailties. But as this article from ‘The Economist’ conveys, the constituents of GDP will be an important factor in deciding whether or not the increased investments will have sustainable impact on GDP.

Let me try to give a brief summary of the above article:
GDP = Consumer Spending + Government Spending + Investments + (Exports – Imports)
Further breaking down, GDP = (Household Spending + Corporate Spending) + Government Spending + Investments + (Exports – Imports)

If growth in GDP is not accompanied by growth in Household Spending, that growth in GDP would be short term and would not be sustainable in the long run. Hence for a sustainable and long term growth in GDP, the Governments should target increasing contribution of Household Spending to GDP.

Economic Ramblings

Cross posted from my other blog: Lifestyle Investments

Monetary Policy, Fiscal Policy, Inflation, Interest Rates – some of the popular terms any student of Economics will go through, somewhat boringly, in their introductory courses. These concepts when linked to the real world can throw some interesting viewpoints about the various burning issues. In the last 12 months, the central banks/Governments of most countries have, more or less, uniformly and uncharacteristically followed expansive monetary policies to the extent of bringing interest rates close to 0%. This is inline with the Governments’ fiscal policies which are more or less expansive – at least at planning level. An expansive monetary policy and expansive fiscal policy will ring a nice note in one’s ears that things are going fine with the economies. In most cases, this could be true; it may not be so this time around.

If the Governments go for an expansive fiscal policy, the Government will spur spending. For spending, the Government needs money – there are multiple options for the Government to get the money. One, it can print money; two, it can issue bonds and raise debts. The former has its own implications on interest rates and the dreaded fear of deflation resulting in increase of the real cost of borrowing. The latter, however, depends on some other factor so far not mentioned: Debt-to-GDP ratio among other things. The Government’s ability to borrow is inversely proportional to the Debt-to-GDP ratio – less the debt to GDP, the better the borrowing ability of the Government – sounds very intuitive.

There is always a partisan view of the credit rating agencies’ role in the financial world. Irrespective of the side you are in, there is a considerable weight attached to the ratings given out by these agencies. It is only common-sense to believe these agencies downgrade those countries with less borrowing power and less repaying capacity. A very simple indicator of these is the debt-to-GDP ratio. Let us take the case of India. If Debt-to-GDP ratio increases (as this would be most likely the case in the late recession / early recovery stage of the business cycle that we are in; as the GDP would not rise as fast as the rise in debt), the agencies downgrade the ratings of the Government. If this happens, there is a double whammy effect as the existing Government bonds would lose value, investors may begin to dump and the Government would be at a disadvantage at raising money from the markets. Essentially, the market forces would be against an expansive fiscal policy. This is very pertinent in India’s case with a Debt-to-GDP ratio of 58% (compare this to Chinese Debt to GDP ratio of 18%) – so Government may not be able to follow expansive fiscal policy along with an expansive monetary policy.

If it persists with expansive monetary policy in this scenario, there would be too much money chasing too little economic activity, leading to the most commonly known economic term – Inflation. With so much political sense also attached to Inflation, no Government will be willing to let this happen. So, are we heading towards restrictive monetary and restrictive fiscal policies: not likely as this again also has a political and economic cost attached with the R-word and no one wants it. All this means is that the Government has to raise money from somewhere without losing its credit worthiness. The likely sources, I believe, would be PSU divestments, tightening of personal tax regime among other things. All this means is the Government would not be able to undertake a 'market-friendly' budget this time - expect no major tax cuts, duty cuts etc.

The scenario mentioned about India does hold true for developed economies like US (whose monetary policies are more expansive and debt-to-GDP ratio is higher). If China believes the US dollar denominated treasuries are downgradeable, it would be Armageddon – again in 2009. Brace yourself.

Cash is King

It is absurdly late for a post on the topic, but still I am an earnest believer of 'better late than never'. All those enthusiastic dabblers and knowledgeable charlatans in the capital markets it is better to keep your money 'safely' (stress here) put in Fixed Deposits and the like.  I expect the current interest rates to be the peak in the immediate future, so you can lock in a nice premium if you enter into the 10% fixed deposits which are currently in the market. I expect the worldwide credit crisis to trigger a wave of liquidity infusing strategy across central banks - the same might be followed by RBI and the interest rates can be expected to drop.  Keep your money safe and at the same time earn more by entering into fixed deposits NOW.

Profiting from Mortality

There is no limit to the creativity of man, especially those from Wall Street.

At the outset, it may seem like a simple Asset backed investment. The finance engineers have cooked up a product which is backed by the Life Insurance settlements of numerous people - the earlier the underlying policy holders' death - the sooner the profits. No wonder these products are termed as 'Death' Bonds. The best part about this is well summarized in the following,

Firms say death bonds should return around 8% a year, right between the expected returns of stocks and Treasury bonds. Moreover, they're "uncorrelated assets," meaning their performance isn't tied to what's happening in other markets. After all, death rates don't rise or fall based on what's happening to commodities, say. Uncorrelated assets like these are highly prized in an increasingly connected global financial system.

I now clearly understand what an 'uncorrelated' investment is worth - life. What is not clear to me in such products is how the underlying policy holders are ready to accept the securitization concept when people are placing (though not explicitly) their bets on their death. The speculators may take out policies on the individual's behalf, pay them something up front, cover the premiums and then wait for the people to die. Seriously macabre. The most important of all questions in my mind is how these bonds be valued? The underlying policies may be those of healthy 30 year olds or octogenarians or terminally ill patients.