In these uncertain and volatile market conditions, investors are flocking to invest in debt securities to ensure not only stable and certain returns but more importantly capital protection
THE GLOBAL MELTDOWN
Across the globe, financial and economic markets have taken a severe beating and there are expectations of recession in developed countries. In this backdrop, the Indian markets have also been affected but not as badly as the others.
BETTER SAFE THAN SORRY
Investors have seen their wealth, especially in shares, erode faster than they would have imagined or liked. Thus, investors are now increasingly flocking to invest in debt securities. So what are their options and the pros and cons of each investment avenue.
Let’s take a look at some of the attractive ones:
Government Securities:
The bond yield on short term (1-year) government securities (g-secs) is currently approximately 8% to 9% p.a. Due to the inverse relationship between bond prices (carrying fixed interest rates) and interest rates, the current trend of rising interest rates have brought down the prices of bonds and gains thereon. On account of this, the returns on medium-long-term debt funds, including MIP, have been very low over the last year.
Thus, it is advisable for investors to maintain/invest in lower portfolio duration i.e. short-term products (directly in g-secs or through mutual funds in debt mutual funds discussed hereunder) to minimise the impact of rate increases. From a tax standpoint, interest/ short-term capital gains and long-term capital gains from g-secs is taxed at the regular and lower rate of income tax, respectively.
Bank Fixed Deposits:
Banks are now offering higher rate of interest say 10.50% on a FD of a year. From a tax standpoint, interest on FD is also taxed at the regular rate of income-tax ranging from 10.30% to 33.99% and subject to tax deduction at source (TDS) provisions.
Debt Mutual Fund:
Debt funds are tax-efficient for investment since dividend on debt funds is tax-free (however the debt fund would be liable to pay tax on distributed income [DDT] ranging from 14.1625% to 28.325% depending upon the type of holder and type of debt fund) and long-term capital gain (holding period of more than 12 months) is taxable at the rate of 10.30% (without indexation) or 20.60% (with indexation). For an investor falling in the highest tax bracket of 33.99% planning to park funds in debt funds, for short-term investment (holding period not exceeding 1 year) dividend option and for long-term investment (holding period exceeding 1 year) growth option would be more tax-efficient.
Zero Coupon Bonds:
National Bank for Agriculture and Rural Development (Nabard) is issuing ZCB as Bhavishya Nirman Bonds which a 10-year product having issue price of Rs 8,500, face (maturity) value of Rs 20,000 to be listed on the Stock Exchange implying a compounded annualised pre-tax yield of 8.9444%.The table shows that the post-yield is different for each investment and one needs to decide as to invest in which debt instrument considering the pros and cons thereof and which tax bracket one falls in.
Wednesday, June 10, 2009
Saturday, March 21, 2009
Good and Bad deflation
What id Deflation?
In common usage deflation is generally considered to be "falling prices". But there is much more to it than that. Often people confuse deflation with disinflation or with Depression (as in "the Great Depression"). These three terms are related but not synonymous.
According to Investorwords.com the definition of Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation.
What casues Deflation?
For a true understanding of both Inflation and Deflation we need to understand Supply and Demand. Just like every other commodity there is a supply of and a demand for "Money".
Price levels are the direct result of the relationship between the supply and the demand for any given item. But the value of the money used to pay for those items is also subject to the same relationship.
For the sake of simplicity let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00 each.
If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.
If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation). This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending).
So far we have only looked at part of the equation, the supply of money. But what happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢.
This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth.
This is exactly what happened in the late 1990s , with cheap productivity available from former Communist countries the quantity of goods is increased while the money supply increased at a slower rate.
In modern credit based economies a deflationary spiral is caused by the popping of a bubble, either in equities, or the collapse of a command economy which had run at a higher level of production than it could actually support. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing. Business, unable to make enough profit no matter how low they set prices, are then liquidated. Banks then get assets which have fallen dramatically in value since the loan is made, and if they sell those assets, they further glut supply, which causes another round of price decreases, and more business to go bankrupt, which results in another round of foreclosures. To stop the deflationary spiral, banks will often simply not collect on non-performing loans. This stems deflation for only a short time, because they must then constrict credit, since they do not have money to lend, which reduces demand and so on.
The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined to be a contraction of the money supply. Under this definition, the Austrian school sees deflation as a cause of a general fall in prices, not a general fall in prices itself. They attribute the other main cause of a general fall in prices to be an increase of productivity relative to the money supply.
Austrians view increased productivity (the first scenario) to be a good cause of a general fall in prices, while deflation (the second scenario) as being a bad cause of a general fall in prices. Austrians contend that in the first scenario wages will remain the same because of the unchanged money supply but that a general increase in wealth will be reflected in lower prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario. However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth. In addition, Austrians believe that deflation causes negative distortions in the economy with debtors and creditors as well as other areas.
Is Deflation Good or Bad?
What is Good Deflation?
Good Deflation should not be considered as a hypothetical situation. It is very much a real condition of the economy, characterized by substantial growth and development in some sectors of a country, despite the fact that the prices of products in these sectors has been reducing since a long span of time.
In fact, Good Deflation results from technological progresses, which initiates excess supply of goods.
Its role:
From the consumer's point of view, Good Deflation is immensely beneficial as it helps those commercial sectors like the bank to deal with sinking prices. The banking sector of a country faces such as a situation, when the value of the collateral (securities) for loans decreases remarkably, having low sale value than what was earlier expected. This condition is far more aggravated by public debts and unemployment problem, which display rising trends.
This situation is controlled to considerable extents by the advent of Good Deflation. In the theoretical sense, Good Deflation does not allow the distribution of corporate gains among the employees, in the form of increase in their wages. Instead, decrease in the prices owing to Deflation is transferred to the consumers. This leads to uniform allocation of the profits, involving those also, who are not directly associated with production.
The debtors should evade price fall, which appears to them in the form of low rates of interest.
Good Deflation can only work when people have full faith in the future of the concept, which is closely related with the consumption and investments on their part. In fact, the customers consume and invest to meet their requirements and not the price expectations.
For Good Deflation to exist in an economy, it is required that there is no interference of any strong union, who may insist on productivity gain on behalf of the employees.
About Bad Deflation:
Bad Deflation is born out of trifling demands. It is an economic situation characterized by reduction in the prices not due to developments in the productivities, but because of a lack of demand induced by crashing down of the stock market. In fact, Deflation becomes bad when the consumers save their money for future uncertainties, or in the expectation that prices may lower further.
Its implications and consequences:
It is the cumulative process of very little generation of demand which affects the population of a country at the time of Bad Deflation. Detection of Bad Deflation thus requires an in-depth study of the overall economic conditions of a nation and not just the price of goods.
Owing to Bad Deflation, the consumers who are the potential purchasers become unwilling to invest and buy, considering the future of their money and the country's economy. This leads to a fast fall in the prices, worsening the overall economic conditions further. Under the impact of Bad Deflation, the recessions are virtually all transformed into depressions. In reality, it is not the price fall of Bad Inflation which matters, but the serious consequences it gives birth to.
Indian economy staring at deflation. Is it good news?
India is staring at deflation, or negative inflation, with the official inflation rate this week falling to 0.44% — the lowest since Financial crisis
Competitive economies Ghosts of 1929US mortgage crisisFive facts on stock falls
1977. Food prices, however, continued to be high, with food grains roughly 9% costlier than a year ago, reinforcing a cruel paradox for consumers that they hear about zero inflation but face high prices when they buy their groceries.
With the wholesale price index (WPI) falling by one point to 226.7 for the week ending March 7, 2009 — the same level at which the index was on March 29, 2008 — it now means the year-on-year inflation rate will become zero by the last week of March even if the index for the current year falls no further. TOI had pointed this out last Friday.
As most commodities are becoming cheaper with every successive week in the recent past, deflation is expected to set in even before that. The rabi harvest should see a drop in foodgrain prices too, and that will only accentuate the trend.
If deflation lasts for some time, as seems possible, it would be a new experience for India. Japan went through a decade-long deflation in the 1990s, termed as the ``lost decade'' for that country. At present, most major economies are witnessing disinflation — a lowering of the inflation rate — and some have also seen deflation kicking in. Japan and China have already reported negative inflation rates in the latest data and there are signs that the US, too, could be heading the same way.
While a fall in prices may sound like good news to most laymen, economists see this as an ominous sign of a collapse in demand in the economy. A recent Citibank report echoed this concern in the Indian context saying that the present trend of decline in inflation was not because of any improved efficiency in the economy but because of falling demand. The report warned that this trend would weaken economic activity and discourage investments, which would affect the economy in the longer term.
The fear about investments not materializing is aggravated by the fact that nominal interest rates are at relatively high levels. When prices are falling, this means the real interest rates — the difference between the nominal rate and the rate of inflation — are becoming very high for producers, making it unviable for them to raise funds.
Demands for the RBI to intervene to induce a further round of cuts in interest rates are bound to mount in the face of the latest data. However, planning commission deputy chairman Montek Singh Ahluwalia on Thursday said that the inflation rate would rebound from its present level. While not ruling out the possibility that inflation could go into negative territory, he maintained that it would last for only a few weeks. Hence, he said, it should not be termed as deflation, a term that implies sustained negative inflation.
From the aam admi's point of view, what makes the situation worse is that prices of essential commodities like foodgrains are stubbornly refuse to come down. According to the latest data, the index for foodgrains rose by 9.3% in the week ending March 7 as against 10.06% in the previous week. Under the ``food articles'' head, inflation fell to 7.4% after having been stable at 8.3% in the previous two weeks.
In common usage deflation is generally considered to be "falling prices". But there is much more to it than that. Often people confuse deflation with disinflation or with Depression (as in "the Great Depression"). These three terms are related but not synonymous.
According to Investorwords.com the definition of Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation.
What casues Deflation?
For a true understanding of both Inflation and Deflation we need to understand Supply and Demand. Just like every other commodity there is a supply of and a demand for "Money".
Price levels are the direct result of the relationship between the supply and the demand for any given item. But the value of the money used to pay for those items is also subject to the same relationship.
For the sake of simplicity let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00 each.
If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.
If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation). This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending).
So far we have only looked at part of the equation, the supply of money. But what happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢.
This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth.
This is exactly what happened in the late 1990s , with cheap productivity available from former Communist countries the quantity of goods is increased while the money supply increased at a slower rate.
In modern credit based economies a deflationary spiral is caused by the popping of a bubble, either in equities, or the collapse of a command economy which had run at a higher level of production than it could actually support. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing. Business, unable to make enough profit no matter how low they set prices, are then liquidated. Banks then get assets which have fallen dramatically in value since the loan is made, and if they sell those assets, they further glut supply, which causes another round of price decreases, and more business to go bankrupt, which results in another round of foreclosures. To stop the deflationary spiral, banks will often simply not collect on non-performing loans. This stems deflation for only a short time, because they must then constrict credit, since they do not have money to lend, which reduces demand and so on.
The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined to be a contraction of the money supply. Under this definition, the Austrian school sees deflation as a cause of a general fall in prices, not a general fall in prices itself. They attribute the other main cause of a general fall in prices to be an increase of productivity relative to the money supply.
Austrians view increased productivity (the first scenario) to be a good cause of a general fall in prices, while deflation (the second scenario) as being a bad cause of a general fall in prices. Austrians contend that in the first scenario wages will remain the same because of the unchanged money supply but that a general increase in wealth will be reflected in lower prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario. However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth. In addition, Austrians believe that deflation causes negative distortions in the economy with debtors and creditors as well as other areas.
Is Deflation Good or Bad?
What is Good Deflation?
Good Deflation should not be considered as a hypothetical situation. It is very much a real condition of the economy, characterized by substantial growth and development in some sectors of a country, despite the fact that the prices of products in these sectors has been reducing since a long span of time.
In fact, Good Deflation results from technological progresses, which initiates excess supply of goods.
Its role:
From the consumer's point of view, Good Deflation is immensely beneficial as it helps those commercial sectors like the bank to deal with sinking prices. The banking sector of a country faces such as a situation, when the value of the collateral (securities) for loans decreases remarkably, having low sale value than what was earlier expected. This condition is far more aggravated by public debts and unemployment problem, which display rising trends.
This situation is controlled to considerable extents by the advent of Good Deflation. In the theoretical sense, Good Deflation does not allow the distribution of corporate gains among the employees, in the form of increase in their wages. Instead, decrease in the prices owing to Deflation is transferred to the consumers. This leads to uniform allocation of the profits, involving those also, who are not directly associated with production.
The debtors should evade price fall, which appears to them in the form of low rates of interest.
Good Deflation can only work when people have full faith in the future of the concept, which is closely related with the consumption and investments on their part. In fact, the customers consume and invest to meet their requirements and not the price expectations.
For Good Deflation to exist in an economy, it is required that there is no interference of any strong union, who may insist on productivity gain on behalf of the employees.
About Bad Deflation:
Bad Deflation is born out of trifling demands. It is an economic situation characterized by reduction in the prices not due to developments in the productivities, but because of a lack of demand induced by crashing down of the stock market. In fact, Deflation becomes bad when the consumers save their money for future uncertainties, or in the expectation that prices may lower further.
Its implications and consequences:
It is the cumulative process of very little generation of demand which affects the population of a country at the time of Bad Deflation. Detection of Bad Deflation thus requires an in-depth study of the overall economic conditions of a nation and not just the price of goods.
Owing to Bad Deflation, the consumers who are the potential purchasers become unwilling to invest and buy, considering the future of their money and the country's economy. This leads to a fast fall in the prices, worsening the overall economic conditions further. Under the impact of Bad Deflation, the recessions are virtually all transformed into depressions. In reality, it is not the price fall of Bad Inflation which matters, but the serious consequences it gives birth to.
Indian economy staring at deflation. Is it good news?
India is staring at deflation, or negative inflation, with the official inflation rate this week falling to 0.44% — the lowest since Financial crisis
Competitive economies Ghosts of 1929US mortgage crisisFive facts on stock falls
1977. Food prices, however, continued to be high, with food grains roughly 9% costlier than a year ago, reinforcing a cruel paradox for consumers that they hear about zero inflation but face high prices when they buy their groceries.
With the wholesale price index (WPI) falling by one point to 226.7 for the week ending March 7, 2009 — the same level at which the index was on March 29, 2008 — it now means the year-on-year inflation rate will become zero by the last week of March even if the index for the current year falls no further. TOI had pointed this out last Friday.
As most commodities are becoming cheaper with every successive week in the recent past, deflation is expected to set in even before that. The rabi harvest should see a drop in foodgrain prices too, and that will only accentuate the trend.
If deflation lasts for some time, as seems possible, it would be a new experience for India. Japan went through a decade-long deflation in the 1990s, termed as the ``lost decade'' for that country. At present, most major economies are witnessing disinflation — a lowering of the inflation rate — and some have also seen deflation kicking in. Japan and China have already reported negative inflation rates in the latest data and there are signs that the US, too, could be heading the same way.
While a fall in prices may sound like good news to most laymen, economists see this as an ominous sign of a collapse in demand in the economy. A recent Citibank report echoed this concern in the Indian context saying that the present trend of decline in inflation was not because of any improved efficiency in the economy but because of falling demand. The report warned that this trend would weaken economic activity and discourage investments, which would affect the economy in the longer term.
The fear about investments not materializing is aggravated by the fact that nominal interest rates are at relatively high levels. When prices are falling, this means the real interest rates — the difference between the nominal rate and the rate of inflation — are becoming very high for producers, making it unviable for them to raise funds.
Demands for the RBI to intervene to induce a further round of cuts in interest rates are bound to mount in the face of the latest data. However, planning commission deputy chairman Montek Singh Ahluwalia on Thursday said that the inflation rate would rebound from its present level. While not ruling out the possibility that inflation could go into negative territory, he maintained that it would last for only a few weeks. Hence, he said, it should not be termed as deflation, a term that implies sustained negative inflation.
From the aam admi's point of view, what makes the situation worse is that prices of essential commodities like foodgrains are stubbornly refuse to come down. According to the latest data, the index for foodgrains rose by 9.3% in the week ending March 7 as against 10.06% in the previous week. Under the ``food articles'' head, inflation fell to 7.4% after having been stable at 8.3% in the previous two weeks.
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