Floating interest rate

My bank increased my interest rate by 25 basis points (0.25%) should I be concerned?

Like the case of my friend (screenshot below), the banks have a tendency to increase the interest rate and often without any warning or prior communication.

Does 0.25% matter?

Well I ran a small calculation using an EMI calculator:

If I borrow 25L for 20 years today at 10.25%, I am expected to shell out Rs 24,541/- every month.

However, if the bank increases the interest rate by 25 basis points and I continue to pay the same interest rate, then I need to pay an additional 15 EMI to repay the loan. (no wonder the banks offer to extend your loan duration). Check for yourself in excel =PMT(10.25%/12,12*20 years, 25Lakhs)

15 EMI means 15months of additional debt, and Rs. 3.63L additional as EMI/interest on a Rs 25L loan. That is a whopping 14.52% extra burden!!!!!

What is even worse, fixed interest rate is not fixed, bank will change it to floating after 3 years.  Also they can say that your risk profile has changed (very common with students) and change the interest rate. Everybody knows what floating means, but I am yet to meet someone whose interest rate went down.

 

Repost from my original article at Samuhik

Bonds Part V: Options (Put/Call/Convertible)

No article on indian bond market can be complete without discussing the various embedded options available in them.
1. Convertible Debentures: The holder of the bonds have an option to buy a particular number of common stock (shares) of the issuing company at a pre-determined rate. If prudence is exercised then its a win-win situation for both companies. The issuing company has made their bond issue attractive and hence can offer a lower coupon rate (more operational profit). Also if the stock market is doing well, then they would be able to roll the debt by converting it to equity. Hence it is a backdoor way of IPO/FPO.
You also benefit because it will offer you capital protection because you can always redeem your bond at the face value if the stock market tanks. If you are a buy and forget kind of an investor then buying such debentures of *Blue Chip* companies will enable you earn extra returns if the price goes above the conversion price.

2. Put option: Most infrastructure bonds seem to have a put option. I.e. if the interest rate goes up, then you can encash the bonds and reinvest the proceeds at the prevailing rates. So it is a hedge against rising interest rates. Fixed deposits are popular because the investor can encash them whenever they want. Most bonds don’t offer this flexible put option, but it is a good to have feature in any bond.

3. Call Options: Unlike the Put option, the Call option gives the issuer the right to recall all the bonds from the market. This can never be good for you, because it exposes you to reinvestment risk. i.e. interest rates have fallen and you now end up with money that can only be invested in bonds that offer a fraction of the interest rates. However because of the administrative and bond issuance cost, it does not become economical for companies to exercise this option for <1% difference in rates. (so that is the only relief you get)

Being the last article in the Bond lecture, I would consider myself successful if now you realize investing in bonds (or fixed income securities) is more than just getting the highest interest rates.

 

Bonds Explained: Part 1: FD Vs Bonds

SBI and Sriram motor finance bond issue was oversubscribed many times on the opening day itself would make one wonder why people go for the bond issues. After all Fixed Deposit has many advantages

1. Sovereign guarantee: RBI offers banks a lot of protection enabling them to raise capital from public and RBI itself at a very discounted rate (sometimes at a cost lower than then that of government borrowing) and in return RBI forces a lot of lending norms to ensure a healthy balance sheet and growth in the nation.

What it means: There is an explicit insurance that all customers who have deposited money with the RBI approved bank would get back at least a minimum assured amount. Also what has been seen is that generous bailout packages and doles are given to sick banks enabling them to not default.

1. Flexibility: You can walk into a bank (or order online/phone) anytime and open up a Fixed deposit of whatever tenure that suits you. Also after paying a nominal penalty, one can also close the deposit and withdraw the money back
2. Best interest rate: If the interest rate are up, no problems. You can close the fixed deposit and reopen it at the prevailing rate.
3.

Benefit to senior citizens: I have never understood the financial logic of offering higher interest rate to senior citizens, but they do exist. Bonds make no such distinction.

Compared to that Bonds offer:

1. Higher interest rates: Remember the Risk Return Graph (CAPM http://en.wikipedia.org/wiki/Capital_asset_pricing_model )
2. Higher risk: The bonds of a firm are worth something only as long as the issuer is capable of paying you back (or as in case of Essar… willing to honor its debt). So watch out for shady firms with weak balance sheet issuing debt. However a lot of public sector firms and blue chips regularly issue bonds so there is no scarcity of good issues, but care needs to be made while selecting.
3. Longer duration: 10-15 year bonds are not uncommon, while rarely people go for fixed deposit with maturity of more than 3 years. Hence good quality bonds make an excellent retirement portfolio addition.
4. Less Liquidity: Companies don’t raise capital (from public) everyday and looking at the previous few issues it is a seller’s market. The company decides the interest rate, the terms and conditions (esp. the call schedule) and also when they want to issue the bonds. Also except on the explicit put/call dates it is very hard to get the money back from the company. Also most bonds are very thinly traded.
5. Demat: Now days most bonds are issued in demat format. This helps in liquidity a lot. Even if the bonds are not being traded, you can transfer it to one of your friends or relatives for cash/other consideration. I have done this OTC transaction for both bonds certificates in physical as well as demat format and trust me demat is so convenient (provided you have a buyer)
6. Convertible option/Debentures: A lot of company sweetens the deal by offering a convertible option. Shares for a predetermined price. So if the stock market rises, people can convert their bonds into shares at a discounted price. Else they can always get their money back.

Bonds allow you to capture the wealth created due to interest rate fluctuations. Interest rates are quite high these days and RBI has ruled against possible rate hikes in the future. (not very trust worthy as policies can change in the next quarter) Now say 2 years down the line you have a FD which gives you a solid 10% return and the prevailing FD rate is only 6%. Of course it is very frustrating because the bank will not compensate you for this extra interest rate that you are foregoing. Also FD are not transferable (you can take a loan but sometimes it does not make logical sense), however bonds trade on the basis of YTM (yield to maturity) and allow the holder to exit at a profit hence capturing the benefit of fall in interest rate. (beware you could lose also because of it)

Please look out for a post on Bonds vs Debt Mutual funds.

 

How Interest rate changes effects your stocks.

How the Balance sheets of corporates are affected:
1) Take banks and financial institutions.
Calculating their impact is simple. They pay the depositors a particular interest rate and buy treasury bonds, or distribute it as loans. Many of the fixed deposit, bonds have fixed rates which need to be honored irrespective of the present conditions. So a fall in the interest rates causes higher profits and vice versa.

2) Leveraged industries
These are companies which have taken huge loans for their new plant, expansions etc. Any rise/fall in the interest rates has huge impacts in the interest outgo, hence the profitability.

3) Fall in the sales
The real estate is rising because the interest rates are low and it if often cheeper to pay an EMI then to pay a rent. A rise in interest rates greatly effects the spending of consumers and corporates, less houses, machinary and cars will be bought leading to a slowdown in the production and revenues of the corporates and hence lower profits.

Common sense says, most IT companies, and established Business houses have little or no debt, so their valuations should not be impacted much. But no:

1) Growth oriented companies:
They are traded at very high PE ratios, because their revenues are expected to increase by 30-40% each year and this expectation of future earnings beef up their stock prices.
100 rupees 5.5% interest grows by 1.7 over 10 years but will grow to 1.8 if interest rates is increased to 6%. So any change in interest rate changes the present value of the future earnings and hence changes the stock price.

2) Stable companies:
Their impact is also almost the same. If bond market gives 5.5%, you expect that your blue chip stock gives you at least 7% (1.5% risk premium) through dividends and stock price appreciation. Now if the interest rate increase to 6%, the only way you will get (6 + 1.5 = 7.5%) returns is that if the stock value dips from 100 to 99 ( .5% change in interest rate cause a 1% dip in the stock price)