You’re new to investing. It sounds exciting.

You’ve heard that people have made 10 X on that one stock and been able to spend the kind of money they never dreamed they could. You’ve also heard that people have lost all they possessed in the downturn.

Clearly there’s money to be made but also lost.

How will you, a novice figure out what you should invest in? You’ve also heard that there are all sorts of ‘advisors’ out there trying to sell you financial products for their commission. And you don’t know enough about investing to even judge whether these advisors are genuine or not. So, here’s what we suggest:

Understand your financial needs and goals first – both short term and long term. Do you want to fund your honey moon, buy a home, fund your child’s education, plan for your retirement? Once you know your financial goals, you can determine how much money you need to achieve them.

Figure out when you need the money i.e. your time horizon.

Know your risk appetite. Are you the type of person who won’t sleep at night if the stock markets fall or are you a risk taker, willing to risk it all for the prospect of making it big? Maybe you are somewhere in between the two extremes but lean towards safety?

Once you have the answers above, look into the financial products that will help you fulfill your goals.

There are several investment options to choose from right from buying gold, to buying property, investing in companies through debt or equity and the list goes on. Investing requires research, regular monitoring and experience.

Many of us might be tempted to invest directly in the stocks of a few companies that we know and which we expect to do well. But do we really know these companies inside out? Have we analyzed their annual reports, the industry they are in, their competitors, their business-model, cost-efficiency, quality of their management? No? No time? Not enough knowledge on what to research?

Then, as a first time investor, we suggest you start with mutual funds because:

They are managed by seasoned professionals If you feel that mutual funds are the way to go, then you need to decide what type of mutual fund suits your needs. Now, let’s look at the various types of mutual fund options:

• Equity Funds
• Debt Funds
• Balanced Funds

Equity funds generally hold shares of companies that are listed on the stock exchange. Buying a stock in a company basically means that one becomes partly an owner of that company. What this means is that as the company does well and grows, the stock price could appreciate, depending on the specific circumstances of the company and the general economic conditions. Hence as an owner, investor in the stock, one immediately benefits from this. But the downside is that the reverse is also true. If the company fails to perform, the stock price could come down. Equity mutual funds have the potential to provide high upside but your capital may not be protected. If you are the sort of person who has long term financial goals and can afford to take risks in return for potentially higher rewards, an equity mutual fund could suit your needs. The rule of thumb is that you can afford to take more risks in your youth than as you approach retirement since your time horizon is much longer, which increases the likelihood that equities will perform well and give a goeturn.

Debt funds invest your capital in bonds or money market instruments. Investing in these instruments doesn’t make you owner of a company like equity would, but you become basically a lender and the company is the borrower of the amounts invested. The interest rate is agreed. So you know in advance what your investment will be worth over a period of time. In general the company will pay back the borrowed amount at the end of a certain period. The risks are limited as is the upside. If you need to ensure that your capital is protected but still would like to earn more than you would in fixed deposits, debt mutual funds are a good option. Debt funds help you beat inflation and provide income but don’t give you the upside potential that you would get in an equity fund.

If you need a mix of safety and growth, a balanced fund could be the answer. A balanced fund usually has a stock component and a bond component. It provides safety, income and some capital appreciation. You could also choose balanced funds that have a high equity component, if you are looking for growth or funds that are skewed in favor of debt if you are looking for income and security. If you have a short investment horizon and looking for security then a balanced fund with a high debt component could be suitable.

It’s always a good idea to diversify – don’t put all your eggs in one basket, even if you have long terms goals and are a risk taker. Consider buying gold, investing in debt and equity funds as well – the percentages can vary based on your requirement. You never know how the future will pan out and it’s better to cover all basis while always keeping in mind your goals.

Now that you have the knowledge you need, go ahead, find out how you can start investing.

The easiest and the simplest form of calculating interest on your investments is simple interest. Simple interest is the interest earned on the initial investment made. Say, you have invested ₹ 1,00,000 at 12% per annum for a period of fifteen years with returns calculated by using simple interest.



The interest earned at the end of three years would be ₹ 2,80,000 i.e. ₹ 12,000 each year. Here, the base for calculating interest remains constant. Generally, term deposits which are for less than six months offer simple interest. Most financial products, however, work on the principle of compounded interest. Compounding of interest is nothing but computing interest on the initial amount invested and also on the accumulated interest of previous periods. Simply put, it is earning interest on interest.

Continuing with our earlier illustration, if ₹ 1,00,000 is invested at 12% p.a. compounded annually, at the end of three years, the interest earned would be ₹ 4,47,356.58 . Unlike simple interest, the base for interest calculation increases every year as the interest is re-invested. In the above illustration, the difference between the two is low since the amount invested is for a lesser duration and the frequency of compounding is only annual.

The difference becomes more significant with longer periods and more frequent compounding as simple interest grows in a linear fashion while compound interest grows exponentially. While compound interest is better than simple interest, there are three points you should keep in mind to harness the power of compounding:

Start early

The longer the investment horizon, the more the interest on interest earned and hence you have time working to your advantage.

 

Let’s take an example. Both Karan and Kareena are 60 years old and are friends who reunited after a very long time. Both of them are discussing about the investments they had made when they were young. Both of them invested different sums of money for a period of 10 years i.e. Karan invested ₹ 15,000 every month whereas Kareena invested only ₹ 5,000 every month. Karan started the investments when he was 35 years old till he turned 45 while Kareena started investing from her 25th Birthday till she turned 35. Both of them continued to hold their investments till they turned 60. On her 60th Birthday the value of the ₹ 6 Lacs invested by Kareena had reached ₹ 1.97 Crores, but Karan’s investments of ₹ 36 Lacs had only become ₹ 1.49 Crores, even though Karan invested more money than Kareena. How is this possible?

Karan’s started his investments when he was 35 and Kareena when she was 25. At 60, Kareena’s money was invested in the avenue since she was 25 i.e. for 35 years while Karan’s funds remained invested only for 25 Years. Kareena’s money got compounded for 10 extra years and hence made a lot of difference today. Hence, it is said, starting early is always beneficial for accumulating significantly higher returns than starting to invest at a later stage.

Shorter interval, greater impact

Compounding cycle is nothing but the frequency or interval at which the interest multiplies. Compounding can be done on daily, monthly, quarterly, half yearly or annual basis.

The shorter the interval of compounding, the greater the impact. This can be understood with the help of the following illustration.

Ram invests ₹ 1,00,000 in two asset classes for a period of three years. Asset X gives a return of 10% p.a. compounded quarterly, while asset Y gives same return of 10% p.a. but is compounded annually. At the end of three years, the value of Asset X is ₹ 1,34,489 while that of Asset Y is ₹ 1,33,100. As the frequency of compounding increases, the difference becomes significant.

Higher the rate, more you gain Higher the rate of returns, the more you can accumulate. No wonder why experts advise investing in equities if one has a long investment horizon; they offer a better potential rate of return over the long term. This is the magic of compounding and you only need to keep these small points in mind to make this magic happen for you. As the famous Einstein quote goes “He, who understands the power of compounding, earns it and he who doesn’t pays it”.

The dictionary meaning of wealth is abundance. When spoken in the context of money, it would obviously mean an abundance of money. Well, this may seem a strange explanation because money is a limited resource for all of us after all. In fact, since most of us face the issue of having limited wealth, we need to prioritize our needs in order to ensure that we use this resource in the most optimal manner to fulfill the most important needs or goals.

Typically, all the money that is surplus to you at the present moment could make up your wealth. It may of course be needed in future to meet your financial commitment. Your wealth could be in the form of property, deposits, gold, shares and other such assets.

The important determinants of wealth

The amount of gross wealth that you can potentially build up in your lifetime (ignoring the utilization on financial goals for the sake of simplicity) typically depends on three main factors namely:

• Amount of savings
• Return that your savings earn and finally
• The length of time that you allow your savings to grow.

Here is a detailed look on how each of these factors affect your wealth.

Importance of saving and investing towards wealth creation: It takes money to make money; just as it takes wheat to grow wheat. A healthy savings rate is the basis for creating wealth. This could of course raise the question as to what a healthy savings rate actually is. Well, it simply is the rate that enables you to achieve your financial goals, given your investment temperament and preferences. Remember, it is your savings and not gross income that makes you wealthy.

Importance of returns in wealth creation: It is quite obvious that higher the return that your investment earns more is the wealth that you are going to create for yourself. But how high a return is good enough? Well, this again is a question that your financial plan alone can answer. Your investments have to earn a return which is enough to meet your financial commitments. But at a very basic level, your post tax investment return should at least match the inflation levels just to stay afloat. If the return falls below the prevailing inflation level, your wealth would be eroded or destroyed. The purchasing power of your wealth weakens gradually over time if it underperforms the inflation level. So, inflation would be the floor level that your wealth would have to earn post-tax over time, just to stay where it is in terms of relative value.

And what is the highest level of return that you can or should aspire for? This will in practice be determined by two factors:

Your risk profile

What is the level of risk that your financial position forces you to take? If the gap between your present and future is large, you may need to take on quite a bit of risk with your investments in the hope that the potentially higher returns would help you bridge the gap. But even if this gap is large, what if your financial situation is such that you cannot afford to take risk? For example, you may have a large amount of loan to repay or your primary, earned income itself is too unstable or uncertain. In this case you may not be able to expose your investments to a high degree of risk. And finally, are you comfortable with the gyrations of the equity market? If your investments are going to keep you awake all night, your wealth would mean little to you.

Financial prudence.

Your risk profile is only one part of your investment puzzle. The other part is about financial prudence. Even if you have the requisite risk profile, is it wise to put all your money in one risky asset? What if the asset underperforms for an extended period of time? What if you need some money at short notice? It is always prudent to spread your investment among multiple asset classes because: Different asset classes perform differently across time periods.

Your portfolio downside would be limited as chance of all assets declining simultaneously is remote. Return should always be measured through the prism of risk taken.

A prudent asset allocation pattern that takes care of your risk profile and return requirements could be the secret of your success. You need to allocate your investments among the various assets according to this pattern and more importantly rebalance back to the original allocation periodically. As different assets perform differently during any given time period, your allocation is likely to get skewed towards the strong performer which increases the risk of your portfolio.

Finally, building wealth takes time.

Just as it takes years or even decades for a seed to grow into a tree, your wealth too needs to be given sufficient time to grow. With adequate time, the magical power of compounding ensures that your wealth is multiplied multifold. As the graph below depicts, this growth is not uniform over the time period but is more back loaded. That is maximum growth happens towards the latter half of the investment period.

The above is for illustration purpose only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.

You would notice that nearly two-thirds of the growth in the investment value is in the last ten years of the thirty year investment. It therefore becomes crucial that you start your investment at the earliest and allow compounding to magnify your results over time.

In a nutshell:

High earnings alone cannot make one wealthy. It is the discipline and financial prudence in utilizing those earnings which are the true determinants of wealth.

ELSS i.e. Equity Linked Savings Scheme is a type of mutual fund that qualifies for tax exemption under section 80 C and had a lock in period of 3 years. As the name suggests, the scheme invests majority of corpus in equity instruments.

Who should invest in ELSS?

ELSS is a good tax saving option for investors with high risk appetite, as the returns in ELSS are linked to the equity market. However, over a longer time horizon equity has a potential to generate attractive returns.

Options while making an investment in an ELSS:

An investor wishing to invest in an ELSS scheme can opt for either lump sum investment or systematic investment plan (SIP). SIP allows one to achieve tax saving in a systematic manner. Also an investor can choose to invest in the growth, dividend or dividend re-investment option. A growth option allows capital appreciation due to the compounding nature of investment while the dividend payout option provides liquidity. Post investment, one cannot change the investment option during the lock in period.

Benefits of investing in ELSS:

1. Dual benefits- It provides dual benefit of equity investing along with tax savings.
2. Tax free returns – Income/returns in form of Dividend or Capital Gains (on redemption) are totally tax free.
3. Lower lock in period – In comparison to the various other investment avenues under section 80 C of the Income Tax Act, ELSS has the shortest lock in period.

The investor can avail the following tax benefit:

Assuming investor falls in highest tax bracket
Amount invested	150,000
Tax @30%	45,000
Cess @3%	1,350
Total Tax Benefit	46,350

Investor will get a tax benefit of Rs. 46,350

*Assuming highest tax bracket i.e. tax rate of 30% which includes education cess of 2% and secondary and higher education cess @ 1%. Information on tax benefits are based on prevailing taxation laws. Kindly consult your tax advisor for actual tax implication before investment.

If you keep Rs 100 locked in a box and do not open it for a year, the money will still be there. However, during this period, prices of consumption goods will have risen: what cost Rs 100 a year ago may probably cost ten or fifteen rupees more this year. This is the impact of inflation. Because of inflation money doesn’t keep its value. Inflation eats away your savings, bit by bit.

Historically, inflation in India has varied , but has rarely fallen below 5% per year for a sustained period. The long-term average over this entire period is about 8%, which means that something that costs Rs 100 at the beginning of a year, would cost Rs 108 a year later. This many not sound like a lot, but inflation is persistent and has an impact year on year on year etc. So much so that, if you have set aside Rs 1 lakh 30 years ago and assuming an annual inflation of 8%, it would be worth about Rs 12,500 now. That is a decrease of 87.5%!

Inflation is an important reason to consider investing instead of just saving. The interest you earn on your savings might not be high enough to beat inflation. The idea is to invest in instruments that over a longer period of time beat inflation. This will help you to at least retain the value of your hard-earned cash!

KEY POINTS

• Inflation is the increase of prices of consumption goods over time.
• Inflation thus erodes the value of the money you have today.
• Saving, but more importantly, investing could help in generating a return that will beat inflation and thus maintaining or even growing the value of your money over time.

It’s a vicious circle we are living in today. Consumerism is big factor that deters our habit of saving as we end up spending most of our earnings. When we fall short of money, credit cards and personal loans come to our rescue. The moment we are asked about saving some money we have a standard excuse: “By the month end nothing much is left so how can we save?” As they say “Earn to spend and spend to earn”.

In this complete cycle, the most important thing we are ignoring is the future.

When we compare ourselves to our parents’ generation, we are going through radical changes in the way we live. Our parents’ generation took everything slow and easy but the scenario is quite different for us. The pleasure of owning a car in our 20s, pressure of buying a house in our 30s, dream of travelling across the globe, wish to provide best education for our children etc has changed the financial dynamics of an individual. To fuel all these dreams, we need money!

Imagine a scenario where your daughter is ready for her higher education, you would need Rs. 15 Lakhs for the same. If you haven’t planned for higher education, it would be a very painful exercise to arrange for money and the next best possibility is compromise.

How will we manage to accomplish all that is mentioned above if we don’t have the simple habit of SAVING! Once we make-up our mind, the next question that comes is how much should be saved every month?Globally the general thumb rule for savings is;

Just investing money in anything is not going to help. Investing money is a simple but a structured process that requires discipline and patience. The money saved should be invested in the right investment products. Whether you are working as an employee, self-employed or as a businessman, your earnings are directly proportional to the amount of time you invest physically doing certain work. But investments work round the clock & do not need your physical presence to grow!!!

The purpose of investing should be to fulfill your dreams and this could be termed in a simple way as “Financial goals”. Without a goal or purpose, you might not save at all or use up the funds for wrong reasons.

End Goal of any investment is to give you Financial Freedom! Reach the financial goals without any stress or sense of burden.

Process of Investing in Mutual Funds:

1. Know Your Customer (KYC): It is mandatory for any investor to get the KYC done before dealing in Stocks, Mutual Funds, Portfolio Management Services etc. This is a onetime exercise, done through SEBI registered intermediary (Mutual Fund advisors, brokers, Mutual Funds etc). Furnishing PAN is mandatory for mutual fund transactions except for Micro SIP investors (investing less than Rs. 50,000/- in a FY in mutual funds).Any of the documents in each of the category should be submitted for completion of KYC formalities:
2. The documents like bills and statements should be not more than 3 months prior to the date of application.Along with the above said Identity proof and address proof document, a prospective investor should submit the photograph along with the KYC application form. The documents and the form must be submitted in physical form, this process cannot be completed online.Preview of the KYC form:The form can be downloaded from this location: http://www.amfiindia.com/know-your-customer
3. Investing in Mutual Funds:Off-line: Once the KYC formalities are completed, a prospective investor could use the service of a financial intermediary called as Mutual Fund Distributor, walk into the office of the Mutual Fund Company directly or the office of the Registrar & Transfer Agents. Mutual Fund distributors could be Banks, Non Banking Finance companies or Individual Financial Advisors. The required documents are:
   • Mutual Fund application form duly filled up
   • KYC Number
   • Payment instrument – Cheque or Demand Draft. Cash deposit challan incase the AMC is accepting Cash
   Based on the application submitted, the Mutual Fund Company would allot the Folio Number which represents the investment account held by the investor. The details of the investment would be furnished in “Account Statement”, which would talk about date of investment, unit purchase price, number of units held and current value of the portfolio etc.Online: KYC formalities should have completed before investing in Mutual funds. Not all the mutual funds would allow new investors to start investing online. To invest in mutual funds online, a client needs to visit website of the Mutual Fund Company or AMC and complete the registration online. Online login and password would be created, using which investments and other transactions could be done.
4. In Person Verification (IPV): In addition to KYC formalities, IPV is an additional requirement mandated from January 1, 2012. This means any SEBI registered intermediary – NISM & AMFI certified distributors who are ‘Know Your Distributor’ (KYD) compliant, are authorized to conduct In Person Verification (IPV). For conducting an IPV, the intermediary while completing the KYC formalities would not only collect the documents like Identity proof and Address proof but also physically verify the same. The copy of documents collected must be attested by the intermediary after verifying with the original documents.

Introduce savings into your routine

Health and wealth are interrelated in more than one way. While making exercise a part of your routine can improve your health, saving and investing regularly can build your wealth. Here are two easy things you can do today to start your journey to financial well being.

Put aside a fixed amount: People who struggle with their finances often complain that they can never seem to save anything to invest in the first place. This is because they have always been waiting for money to be leftover after they have made their expenditures. It is a common mistake that a lot of us make. A good idea can be to simply set up an automatic bank transfer to an investment just after you receive your salary or income. You can use your bank’s net banking service to do it yourself or you can go to your bank’s branch and leave instructions with them. This would ensure that as soon as you get paid, your investments are made… even before you have a chance to spend that money.

Where to invest: If you are uncomfortable with complicated financial investments and do not really understand how a lot of them work, you should definitely consider a Systematic Investment Plan (SIP) in a suitable mutual fund. There are mutual fund schemes that suit all sorts of investors with different risk profiles.

Why choose a mutual fund?
Mutual funds are managed investments. This means that qualified and professional fund managers oversee the funds that you invest. If you were to manage your funds yourself, you would need a substantial knowledge of the equity and debt markets to make the right decisions. If you are a complete novice, you should always opt for managed financial products. Mutual funds invest across a wide range of asset classes. You can use your favourite mutual fund to invest in stocks, bonds, commodities or even other mutual funds!

What are the advantages of a mutual fund SIP?
Mutual fund SIPs allow you to invest as little as Rs. 1,000 per month automatically into mutual funds. If you have just begun to save and you are not sure how much you can spare for savings each month, just start with one SIP and keep adding SIPs as you grow comfortable. Just like splitting your exercise into smaller manageable bits, you can do the same for your investments as well. SIPs also allow you to build a corpus over a long-term investment and take advantage of Rupee-cost averaging. This means when the markets are down you get more mutual fund units and when the markets are on the higher side you get better returns. Over a long period of time if you keep investing little amounts of money through a SIP, you will average out and beat stock market ups and downs.

Is there something I need to do before I invest?
You may need to read a bit about these funds in analysts’ reports on various mutual fund schemes in different categories. These reports are easily obtainable online. If you have trouble going through these reports, you can take the assistance of a financial advisor. Financial advisors are professionals who help investors manage their money and invest better.

How can I start a SIP?
Starting a SIP is easy. To do so, you will need to choose the mutual fund scheme, the frequency of deduction for SIP installment, the SIP tenure and the SIP installment amount. Before you start SIP in a scheme, you will need to make an initial investment in the scheme. To do this, you need to fill a mutual fund application form along with the SIP enrollment form. You will also need to furnish a Know Your Customer acknowledgement. Your SIP enrollment form has details such as the SIP start date, frequency of the SIP, investment period, etc. You have the option to issue post-dated cheques for your SIP or opt for a direct debit mandate from your bank account. If you opt for the direct debit option, your SIP will be deducted from your bank account at the chosen frequency automatically. Keep in mind that it can take up to 15 to 21 days for a new SIP request to be processed.

Conclusion : After you have set up your SIPs, you can be worry-free that at least some of the money that was being spent before is now being accumulated to build your wealth. This is a big step. You are also now learning more about how to put something aside and let it grow with time. Soon it will be time to start enjoying the turnaround in your financial health.

A million dollar question which people tend to ask before investing is, “when is the right time to invest in mutual fund/equity market?” Conventional wisdom says – enter when the markets are low or enter when P/E ratio falls below a certain threshold so on. Multiple theories advocate right time of investing. The fear is “what if I invest and market crashes after I invest?”, in such cases portfolio would be under loss.

Let’s assume, few of our investors were accurate in predicting the market lows and invested in Sensex/index fund right at bottom of the market in the given period. Let’s say some of the investors got carried away with the Bull Run and invested Growth Fund at the market peak. How much of difference would it make in the short term and in the long run;

One time investment in Sensex – at various market levels The table given below talks about the returns generated by both the set of investors who invest when the market was low and when the market was high; 

Source of Index values: www.bseindia.com

The process of wealth creation requires patience and discipline. In Short term investment horizon, the performance of the portfolio can be extreme, but in long term the performance normalizes. Irrespective of the time of entry, to reap the benefits in equity markets an Investor should stay invested for at least 7 to 10 years or more. In the long run, equity investments have always out performed inflation consistently. Investing in mutual funds, would add the benefit of active fund management and tends to outperform the benchmark (normally Sensex/Nifty incase of large cap funds) in the long run.

When you are looking at achieving long term financial goals, there is no right or wrong time to enter the market. Start today!

Ramnath 24 year old design engineer works with an automaker andlives with his family in Chennai. He is a well-read man, loves music and is inspired by his father & grandfather. Both, his grandfather and father,have worked and have saved all their life. Their savings were predominantly invested in fixed deposits (FDs), recurring deposits (RDs) and traditional insurance plans. Ramnath, has picked up the investment habit from his family and continues to invest in recurring deposits. He meets his colleague Naveen who is investing in SIP since last 1 year and his question to Naveen is why not RD, why SIPs?

Systematic Investment Plan (SIP):

“Little drops of water make the mighty ocean” Systematic Investment Plan (SIP) is nothing but small amount of money invested on a pre-set date every month into specific mutual fund/funds. One of the best ways of entering equitymarket is through Systematic Investment Plans (SIPs) in equity mutual funds, as it brings in an investment discipline for the investor. SIPs help to achieve financial goals by investing small sums of money on a monthly basis that eventually leads to accumulating the required corpus for reaching the goal.

For some investors who are afraid of long term commitments like PPF or Insurance plan, SIPs are the answer. They are flexible;

• SIPs are done in open ended funds where the investors can invest and take out the money any time
• There is no fixed tenor for running SIP. Once the SIP tenor is fixed, it can stopped in between or could be continued even after the tenor by placing the request with respective mutual fund company
• Full and partial withdrawal is possible during or after the SIP tenor
• The SIP amount can be increased or decreased

Just because SIPs are flexible doesn’t mean that the investment horizon could be shorter. Ideally, to reap the benefits of SIPs, the investment horizon should be for longer term. Longer the investment horizon, better the wealth accumulation.

What is rupee cost averaging?

Every common man understands while buying a commodity, buy when the price comes down and sell when price goes up. But when the decision comes to investing in equity we do exactly the opposite.

“What we have learned from history is that, we don’t learn from history” ~unknown

A SIP investor, while investing every month would end up buying more units when markets go down and buying less units when market goes up. Illustration of Rupee cost averaging:

At every market correction an investor would end up buying more number of units. When the unit price goes up, he tends to gain.

What are the benefits of Systematic Investment Plan?

Power of Compounding

Estimated returns from SIP into an Equity Mutual Fund (at an assumed rate of 12% p.a.)

Estimated returns from Recurring Deposit (at an assumed rate of 8% p.a.)

When we look at the corpus accumulated at the end of the tenor, the wealth accumulation is at its best in the long run. As the time given to investment increases, the wealth builds at an accelerated pace because of compounding effect.

As per the illustration given above, the difference between the RD and the Equity Mutual fund SIP, could be more than double in the long run.

Illustration: Systematic Investment Plan (SIP) Performance of a diversified equity fund at different 5 year investment cycles

Illustration Disclaimer:
The above example is only for illustration purposes, purely to explain the concept of the indexation. For more details please consult your Tax Advisor.

Introduction

Mutual funds are usually perceived as volatile investments by most investors and have most recently become a popular avenue of investment. However, contrary to the perception of many, mutual funds do not only invest in equity markets, or in other words, there are other than equity oriented mutual funds too. Debt mutual funds have a substantial share in the Indian mutual fund landscape and therefore, it is important for investors to understand the significant features of these schemes.

A debt mutual fund is a mutual fund scheme that invests in fixed income instruments, such as bonds issued by the government and corporates, debt securities, and money market instruments, etc. The fundamental reason for investing in debt funds is to earn a steady interest income and capital appreciation. The issuers of debt instruments pre-decide the interest rate you will receive along with deciding the maturity period. Hence, they are also known as ‘fixed-income’ securities. They have lower volatility and, hence, are less risky than equity funds. However, this also means that debt investments offer lower returns as compared to equity investments.

We will be discussing how safety, liquidity and returns are differently managed in various types of debt funds.

 Safety in Debt Funds

As has been mentioned above, debt mutual funds are less volatile than equity counterparts. Debt mutual funds invest in debt securities, where interest income is regular, and prices are relatively stable. This makes these funds safer than equity mutual funds. Debt funds also have inherent risks involved, not limiting to Credit / Default risk, Interest rate risk and Liquidity risk. These risks can be mitigated by choosing an appropriate debt fund after studying the characteristics of the said fund.

• ■ Credit Risk – For e.g., If an investor wants to avoid credit default risk, he/she should choose funds which have higher credit ratings and superior quality papers in the portfolio. Credit risk is measured by “Credit ratings”. Credit rating agencies like CRISIL, ICRA, CARE etc. rate the issuer of the bond on their ability to repay by assessing their overall financial health. Besides, investing in gilt funds also helps in avoiding credit default risks as these funds invest in government securities and they possess the lowest credit default risk.
• ■ Interest Rate Risk – Market price of the bond and interest rates carry opposite relationship. Whenever interest rates in the market go up, the market prices of bond come down. Therefore, in order to avoid or minimise interest rate risk, investors should choose debt funds with lower maturity as usually, longer the maturity, greater the degree of price volatility. Interest rate risk is present in all debt funds, but the degree could vary. For e.g., a low duration fund has lower interest rate risk than a short duration fund or a medium duration fund.
• ■ Liquidity Risk – It can be avoided by choosing funds from the overnight, liquid and liquid plus categories which include ultra-short duration, low duration and money market funds. These funds have lower maturities and more liquid papers in their portfolios than longer duration funds. Also, funds with higher credit ratings tend to be more liquid as high rated papers are more in demand in the capital markets.

 Liquidity in Debt Funds

Debt Funds are more liquid as compared to other available traditional savings options as investors can invest and withdrawal, fully or partially, at any time. However, some of them could have an exit load just like fixed deposits. In order to avoid exit loads, investors can choose funds accordingly which do not have exit loads.

Investors seeking liquidity can choose funds from the liquid and ultra-short-term categories which are most suitable for short term parking of funds as they require more liquidity. A Liquid Mutual Fund is a debt fund which invests in money market instruments like commercial paper, certificate of deposit, treasury bills, etc. with a maturity of up to 91 days. The net asset value (NAV) of a liquid fund is calculated for 365 days. Further, investors can get their withdrawals processed within 24 hours). An ultra-short-term fund also invests in similar money market instruments with a maturity between 3 months and 6 months. These funds have no entry and exit loads in most cases and offer the highest degree of liquidity thus acting as an excellent avenue to park one’s surplus cash for short periods of time.

 Returns in Debt Funds

The returns in debt funds come from two sources–the interest rate component and the gain (or loss) on the value of the instrument. The interest income is known at the time of making the investment and are received periodically or on maturity along with the principal. The coupon on a debt instrument depends on its tenor and credit quality. Bonds with longer tenors, typically, have higher coupons. Similarly, bonds with lower credit ratings, which imply higher default risk, have to offer a higher coupon rate to attract investors.

The second component of returns is from an increase in the value of the securities held. This gain in value will add to the coupon income and push up the net asset value (NAV) and returns of the scheme. The gains or loss in the value of the securities is driven by changes in interest rates in the market. When interest rates are on the decline, debt mutual funds appreciate in value as these funds endeavour to benefit from the inverse relationship between prices of debt instruments and interest rates.

The above matrix shows that relationship between risk and returns among debt funds as per the categories. It means that the lower the maturities of the funds, the lesser risk they possess and thus give lesser returns as compared to funds with longer maturities. Funds that target higher total return invest in longer-term debt securities to gain more from any appreciation in value, along with the regular coupon income. The returns from such funds are likely to be volatile since the NAV may move up and down with changes in the value of the securities. They are better suited for long-term investing. Investors should be aware of their risk appetite and financial goals before choosing a fund based on its returns. They should also evaluate the maturity profile of the fund, credit risk (which can be seen by previous credit rating allocation of the fund) and other quantitative data of the fund.

Disclaimers:

CRAMC has used information that is publicly available, and information developed in-house. The information gathered and material used above is believed to be from reliable sources. CRAMC however does not warrant the accuracy, reasonableness and/or completeness of any such information. While utmost care has been exercised while preparing this, CRAMC does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the above. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax advisor before taking any investment decision. The calculation shown, if any, are just examples and are only for illustration purposes, purely to explain the various concepts which are covered in the above. Please note the figures assumed above, if any, are purely for illustration purposes only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.

“Be fearful when others are greedy and greedy when others are fearful”
– Warren Buffet

Everyone tells us that the only way to make profits is to invest our money when the stock prices are low, so that they can earn returns when the prices start rising. Hence investing at the lowest possible levels is an instinctive wish of most investors. When stock prices decline, investors should ideally be tempted to purchase their favourite shares and mutual funds but often wait longer in the expectation of further decline in prices. The prolonged wait usually results in inaction and by the time the markets rebound, the wait seems futile. There are also a large number of investors who get emotionally impacted by falling markets and end up not wanting to invest at all as the fall in their invested value jolts them. Volatile times cause difficulty in effective investment decision making.

Timing the market accurately is a difficult task which is rarely accomplished on a consistent basis. However, the good thing is that one doesn’t need to have a crystal ball to earn profits. A little understanding about how markets can function, and a little more consistency could help you make money, more so during volatile times. Introducing Rupee Cost Averaging. This refers to investing fixed sums of money regularly in a particular mutual fund scheme at different points of time and hence, at different NAVs. What automatically ends up happening is that you buy more units at a lesser price and less units when the price goes higher. This results in the average cost of your investment per unit being lower than the average NAV per unit over time. This is one of the most reliable ways to gain from market volatility.

A great way to harness this strategy is through the Systematic Investment Plans (SIPs) facility offered by mutual funds. SIPs are a great way to reduce the average cost of your investment, which in turn, increases the scope of potential gains.

Consider the following example to understand the benefit of Rupee Cost Averaging vis-à-vis investing through SIP or a lump sum amount at a single point of time. Let us assume a SIP of ₹2000 for a year vis a vis a one-time investment of ₹24,000. The NAVs on the last working day of the months are as follows:

Case 1: Let’s assume an investment of ₹2,000 each month through a SIP in mutual fund scheme:

Month	Invested Amount (₹)	NAV of Fund (₹)	Units Allotted	Units Accumulated	Investment Amount (₹)
Sep 2019	2,000	10.00	200.00	200.00	2,000
Oct 2019	2,000	8.50	235.29	435.29	3,700
Nov 2019	2,000	9.50	210.53	645.82	6,135
Dec 2019	2,000	9.00	222.22	868.04	7,812
Jan 2020	2,000	7.50	266.67	1,134.71	8,510
Feb 2020	2,000	8.00	250.00	1,384.71	11,077
Mar 2020	2,000	8.50	235.29	1,620.00	13,770
Apr 2020	2,000	9.00	222.22	1,842.22	16,580
May 2020	2,000	9.50	210.53	2,052.75	19,501
Jun 2020	2,000	8.50	235.29	2,288.04	19,448
Jul 2020	2,000	9.00	222.22	2,510.26	22,592
Aug 2020	2,000	11.00	181.82	2,692.08	29,612
Total	24,000		2,692.08		29,612

Case 2: Investing ₹24,000 with a one time, lump sum investment:

Month	Invested Amount (₹)	NAV of Fund (₹)	Units Allotted	Units Accumulated	Investment Amount (₹)
Sep 2019	24,000	10.00	2,400.00	2,400.00	24,000
Oct 2019	–	8.50	–	2,400.00	20,400
Nov 2019	–	9.50	–	2,400.00	22,800
Dec 2019	–	9.00	–	2,400.00	21,600
Jan 2020	–	7.50	–	2,400.00	18,000
Feb 2020	–	8.00	–	2,400.00	19,200
Mar 2020	–	8.50	–	2,400.00	20,400
Apr 2020	–	9.00	–	2,400.00	21,600
May 2020	–	9.50	–	2,400.00	22,800
Jun 2020	–	8.50	–	2,400.00	20,400
Jul 2020	–	9.00	–	2,400.00	21,600
Aug 2020	–	11.00	–	2,400.00	26,400
Total	24,000		2400.00		26,400

From the example above, it is evident that a systematic investment plan could be more rewarding in volatile times than lump sum investment due to the ability to generate higher returns by Rupee Cost Averaging- which lowers the average cost of investment per unit. One can thus avoid the trouble of waiting for the best possible time or finding the lowest possible levels to invest in the markets. The returns generated from staying invested during the long term can result in compounding gains. Besides inculcating financial discipline of regularly channelizing a fixed portion of funds towards investing for wealth creation in the long run, SIPs also do away with the need to time the market. Thus, irrespective of whether the market is in a bear or a bull phase, one is able to benefit from both situations and effectively manage the risk-return tradeoff.

To summarize, Rupee Cost Averaging implemented through a systematic investment plan enables to manage market volatility very effectively. However, it should not be taken as a guarantee to earn profits as all mutual fund investments are subject to market risk. To ensure that you gain the most from Rupee Cost Averaging and SIPs, one needs to invest continuously over the long term.

Other advantages of investing through SIP include

 Disciplined Investment: 
It helps one to save regularly and thus inculcates a sense of discipline

 Power of compounding: 
Small, regular investments lead to large accumulation of wealth over time hence harnessing the power of compounding.

 Small Pocket Investment: 
You can invest in a diversified portfolio of stocks with as low as ₹500 per month through the SIP mode.

Disclaimers:

CRAMC has used information that is publicly available, and information developed in-house. The information gathered and material used above is believed to be from reliable sources. CRAMC however does not warrant the accuracy, reasonableness and/or completeness of any such information. While utmost care has been exercised while preparing this, CRAMC does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the above. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax advisor before taking any investment decision. The calculation shown, if any, are just examples and are only for illustration purposes, purely to explain the various concepts which are covered in the above. Please note the figures assumed above, if any, are purely for illustration purposes only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.

The character of debt funds is often undermined by the euphoria over the performance of equities, driven by the news and excitement around the stock markets. A fundamental basis of constructing an investment portfolio is asset allocation, which entails a mix of both equity and debt assets. Debt as an asset class is more oriented towards income as opposed to equity which is oriented towards growth. There is a role for debt funds in an investment portfolio and that shouldn’t be undermined.

A debt fund is a mutual fund scheme that invests in fixed income instruments, such as bonds, corporate debt securities and money market instruments, which are less volatile compared to equities. Such attributes make investments in debt funds suitable for short- to mid-term goals and for investors who want regular income and prefer low risk and less volatile investments.

Another reason to consider debt funds is their behaviour; unlike equities, which are volatile, investment in debt, tends to be less volatile in terms of day-to-day fluctuations in price. All these traits make investment in debt funds complimentary to equities, which make a suitable combination to achieve the right mix of asset allocation. How much you wish to allocate to debt funds in your portfolio is governed by your priority for income and potential stability over growth in your investment portfolio, along with the risk that you can take with your investments.

Inside the debt fund
Just the way equity investments provide you with dividends, investment in debt instruments earns you interest. For instance, in case of investment in a bond, which is like a certificate of deposit that is issued by the borrower to the lender; there are three main features to know about – coupon, par value and maturity, which collectively define cash flows of the bond and timing of these cash flows.

The coupon is the promised interest rate paid at a fixed interval to bondholders; the par value is the principal sum that is returned by an issuer to a bondholder at maturity and lastly maturity, which is the date on which the bond matures assuming all promised payments are paid.

Debt funds also come with specific risks like credit default risk and interest-rate risk. Credit default risk occurs when the fund manager invests in securities that have low credit rating, which could result in a higher probability of default. In case of interest-rate risk, bond prices could fall when interest rates go up, leading to lower returns on your investment. This is attributed to the inverse relationship between bond prices and interest rates.

On the whole, there is a wide choice in the bouquet of debt fund with 16 different types of debt funds based on the Securities Exchange Board of India (SEBI) guidelines. These can be classified based on their indicative investment horizon and investment strategy. You can choose a debt fund based on the time horizon, liquidity needs and your risk appetite. You could select a debt fund category based on your investment need and requirement.

Different funds for different goals

Time horizon	Situation	Fund Type
1 day to 3 months	Emergency funds, Surplus cash, Alternative to savings account etc	Overnight or Liquid
3 months to 1 year	Annual house tax, New gadgets, Advance tax	Ultra-Short Duration, Low duration, Money market
1 to 3 Years	Car purchase, vacation	Short Duration, Floater, Banking & PSU, FMPs,
3 to 5 years	Rebalancing investment portfolio, down-payment for home	Medium Duration, Medium to Long Duration and Credit risk fund
Over 5 years	Approaching long-term goals like child’s education and retirement	Gilt and Long Duration

Disclaimers:

CRAMC has used information that is publicly available, and information developed in-house. The information gathered and material used above is believed to be from reliable sources. CRAMC however does not warrant the accuracy, reasonableness and/or completeness of any such information. While utmost care has been exercised while preparing this, CRAMC does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the above. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax advisor before taking any investment decision. The calculation shown, if any, are just examples and are only for illustration purposes, purely to explain the various concepts which are covered in the above. Please note the figures assumed above, if any, are purely for illustration purposes only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.

Duration is a significant component of debt funds. Economist Frederick Macaulay suggested duration as a way of determining the price volatility of bonds. The ‘Macaulay duration’ is the most common duration measure. It is also the basis on which all the duration funds under the Categorization and Rationalization of Mutual Fund Schemes as per Securities Exchange Board of India (SEBI) guidelines have been defined.

Duration is defined as the average time it takes to receive all the cash flows of a bond, weighted by the present value of each of the cash flows. Essentially, it is the payment-weighted point in time at which an investor can expect to recover their original investment. The importance of duration was experienced with the fluctuation in interest rates, because duration can help predict the likely change in the price of a bond given a change in interest rates.

Another important aspect of duration is that it allows for the effective comparison of bonds with different maturities and coupon rates. For example, a 5-year zero coupon bonds may be more sensitive to interest rate changes than a 7-year bond with a 6% coupon. By comparing the bonds’ durations, you may be able to anticipate the degree of price change in each bond assuming a given change in interest rates.

Upside of duration
Although no one can predict the future direction of interest rates, examining the ‘duration’ of different debt funds you own provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Mutual fund managers rely on duration because it combines several bond characteristics such as maturity date and coupon payments into a single number that gives a good indication of how sensitive a bond’s price is to interest rate changes. For example, if rates were to rise 1%, a bond or bond fund with a 5-year average duration would likely lose approximately 5% of its value.

Duration is expressed in terms of years, but one should not confuse it to be a bond’s maturity date. The maturity date of a bond is one of the key components in arriving at the duration, as is the bond’s coupon rate. For example, in case of a zero-coupon bond, the bond’s remaining time to its maturity date is equal to its duration. This way, when a coupon is added to the bond; the bond’s duration number will always be less than its maturity date. The larger the coupon, the shorter the duration number becomes.

As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. For example, in a bond with duration of 5 years, and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.

Generally, bonds with long maturities and low coupons have the longest durations. Such bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.

As an investor you need to keep in mind that duration is just one consideration when assessing risks related to your debt fund portfolio. Credit rating risk, inflation risk and liquidity risk are other relevant variables that should be part of your overall analysis and research when choosing your investments.

Disclaimers:

CRAMC has used information that is publicly available, and information developed in-house. The information gathered and material used above is believed to be from reliable sources. CRAMC however does not warrant the accuracy, reasonableness and/or completeness of any such information. While utmost care has been exercised while preparing this, CRAMC does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the above. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax advisor before taking any investment decision. The calculation shown, if any, are just examples and are only for illustration purposes, purely to explain the various concepts which are covered in the above. Please note the figures assumed above, if any, are purely for illustration purposes only & shall not be construed as indicative yields/returns of any of the Schemes of Canara Robeco Mutual Fund.

In today’s world, the role of women has undergone a significant change and they can be seen holding important positions and carrying out equal responsibilities as compared to their male counterparts across various fields. We can see women contributing extensively towards politics, sports, business, law and even defence. Such a shift in their roles have not only helped them consolidate their position in the society but also helped them earn their own livelihood without having to depend on others. Therefore, it is important for women to understand investing and achieve financial independence and stability. Along with pursuing high-powered careers and becoming an integral part of a workforce, women should also give thought to becoming financially secure for the long term. It is not just enough to save but to make their money grow. Here are some useful and vital suggestions on how this can be achieved:

• Build a budget and an emergency fund: The first step is to ensure that the financial foundation is solid. In order to do so, a woman should build a budget for her expenses and take out a certain sum of surplus income as emergency fund. It should be of 3-6 months’ expenses and should be liquid in nature so as to ensure that it is readily available in case of emergencies and accidents. She can invest such an amount in overnight or liquid mutual funds so that they can be redeemed whenever the need arises (one day redemption), and the amount multiplies with the help of compounding instead of keeping them idle.

• Define financial goals: An important task for a woman is to list down short-term and long-term goals for both herself and her family. It is essential that before she invests, she should have a set of defined financial goals and priorities like her children’s secondary education, higher education, marriage, her own house, retirement, etc. so that she can plan her investments accordingly. Goals-based investing has shown to be successful, long-term strategy and one that women will likely be adept at. The challenge will likely be less defining the goals and more prioritizing them.

• Start investing early: The best thing to be done for investments is to start early. Longer term savings will compound over time and it especially important to do so as women as investors often find themselves at odds with the clock trying to get everything done. Thus, when they start investing early and consistently, the pressure of fulfilling the long-term goals is taken care of by compounding and regularity in investing.

• Disciplined investment: It is imperative that there should be a disciplined approach to investing. Irregular and inconsistent investing will hamper the invested amount along with the long-term goals to be fulfilled. This can be taken care of by investing through systematic investment plans (SIPs). A SIP helps in planning and realizing correctly the amount of wealth estimated to reach the defined goals. It is also a powerful tool which makes investing a habit and enables in making small investments into a large amount over a period with the power of compounding. Besides, it might be difficult to maintain consistency amidst the hordes of tasks to do on a daily basis. SIPs help take care of that problem by being automatic in nature and thus requires minimum supervision.

• Diversified investments: The saying ‘do not put all your eggs in the same basket’ goes for investing as well. In order to ensure that the investments are safe as well as provide wealth creation, it’s essential to diversify the investments. Equity oriented mutual fund schemes help in wealth creation but have more market risk than debt oriented mutual funds schemes. Debt schemes offer more liquidity and regular income but have interest rate risk and credit default risk. There are hybrid schemes as well which aims at balancing both wealth creation and lesser market risk. Besides, equity-oriented hybrid schemes or aggressive hybrid schemes offer equity taxation benefits.

• Plan for retirement: Retirement for women is equally important especially if there is no option of a regular pension to be received. In order to take care of the financial responsibilities and daily expenses, women should always plan for their retirement. Therefore, in order to not depend on their children or spouses for a steady income post retirement, they should start saving for retirement early. This helps them be financially secure even in the old age and less prone to vulnerability. There are many retirement plans in solution oriented mutual fund schemes which can help with the same.

Apart from the above tips on investing, women should also inculcate in their children the importance of financial planning and appropriate money habits. Children often tend to follow and imitate their mothers’ behaviors and practices. Thus, it is easier for them to learn from their mothers the significance of learning how to plan their finances. Also, it is important that they are aware of their financial conditions right from an early age and be a part of the budgeting exercises and investing processes. This will help them be more prepared in times of emergencies and grow up to be more responsible with their money. While the challenges are many for a woman in her various roles as a wife, mother or daughter, keeping the finances in order and being prepared will not only help her lead a much smoother life but also help in gaining confidence to face any difficulties life might throw at her.

What is Price to Earnings (P/E) Ratio?

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple. P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time. There are primarily two types of P/E Ratio: trailing P/E ratio and forward P/E ratio. Forward P/E ratio tries to predict the earnings of a company basis trends and analysis.

The formula for calculating P/E ratio is:
PE Ratio = Market Value per share ÷ Earnings per share

A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future. Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The higher a company’s EPS, the more profitable it is considered to be.

The formula for calculating EPS ratio is:
EPS = (Net Income – Preferred Dividends) ÷ Common Shares Outstanding

To calculate a company’s EPS, the balance sheet and income statement are used to find the period-end number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It is more accurate to use a weighted average number of common shares over the reporting term because the number of shares can change over time.

P/E Ratio and Investing in Mutual Funds:
In mutual funds, the P/E ratio of a scheme is arrived at by using a weighted average of all the underlying stocks. It is the average of the P/E ratio of all the stocks that the fund’s portfolio contains, proportionate to their allocation within the portfolio. For example, if a scheme is holding INR 20,00,00,000 worth of stock A and INR 30,00,00,000 worth of stock B, the total holdings equal INR 50,00,00,000. Here, 40 percent of this total is held in stock A and 60 percent in stock B. If the P/E ratios of the stocks are 10 and 12, respectively, the fund’s P/E ratio equals 40 percent of 10 plus 60 percent of 12 which is therefore (0.4*10) + (0.6*12) = 11.2

A high P/E would indicate that the mutual fund investment holds mostly stocks that are quoting a valuation premium. This indicates a preference for growth and growth-oriented businesses. In a growth-based approach, the fund manager does not mind paying a high price for stocks that are displaying good growth in profitability.

On the contrary, a low P/E signifies a value-conscious approach. Here, the fund manager is more comfortable investing in stocks that are currently not in demand or where the stock price has been beaten down disproportionately to the fundamentals of the company.

The graph below compares the movement of the Nifty 50 index with its 1 year forward P/E ratio as an illustration:

Source: Bloomberg
Disclaimer: The data/statistics are given to explain general market trends, it should not be construed as any research report/research recommendation.

As can be observed here, the Nifty index has fallen when the P/E has risen above a level of 20. However, we can see that the Nifty levels have started to rise with the fall in P/E ratio. Therefore, an undervalued market could be considered as a choice for equity investment; however, allocation to equity mutual fund portfolios having exposure to quality companies and diversification could benefit over long term.

Key Takeaways

• Price-to-earnings (P/E) ratio helps in understanding if a particular company is overpriced or underpriced
• It also helps in comparing a company with its past record and track its growth
• In mutual funds, P/E ratio can be used to determine a growth-based or value-based investment style
• Investors can refer to the P/E ratios of different mutual fund schemes to suit their investment goals and patterns
• The ratio should be not be seen in isolation and should be considered with other factors such as quality of companies and diversification of portfolios

What is Yield Spread?

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points.

When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets.

How does Yield Spread work?

The yield spread is a key metric that bond investors use when gauging the level of expense for a bond or group of bonds. For example, if one bond is yielding 7% and another is yielding 4%, the spread is 3 percentage points or 300 basis points.

Typically, the higher the risk a bond or asset class carries, the higher its yield spread. When an investment is viewed as low-risk, investors do not require a large yield for tying up their cash. However, if an investment is viewed as a higher risk, investors demand adequate compensation through a higher yield spread in exchange for taking on the risk of their principal declining.

For example, a bond issued by a large, financially healthy company typically trades at a relatively low spread in relation to Government Securities. In contrast, a bond issued by a smaller company with weaker financial strength typically trades at a higher spread relative to G-Secs. For this reason, bonds in emerging markets and developed markets, as well as similar securities with different maturities, typically trade at significantly different yields.

Because bond yields are often changing, yield spreads are as well. The direction of the spread may increase or widen, meaning the yield difference between the two bonds is increasing, and one sector is performing better than another. When spreads narrow, the yield difference is decreasing, and one sector is performing more poorly than another.

Factors affecting Yield Spread
Changes in the yield spread are due to changes in the interest rates, supply and demand of bonds, the risk associated with the bond and economic conditions. The following are some of the factors explained:

• Interest Rates: Any change in interest rates causes the yield on government bonds to change. Since other types of bonds are benchmarked against G-sec yield, any change in G-sec yield may cause other bond yields to change.
• Economic Conditions and Credit Risk: When there is an economic slowdown, company performances are impacted which increase their credit risk. This causes yields on corporate bonds (or PSU, bank bonds) to increase, to compensate investors for the additional risk involved, thereby widening yield spread. When the economy is booming, company profitability increases improving their performance lowering their credit risk. This causes investors to view investments in corporate bonds as favourable, causing yields to fall, thereby narrowing yield spread. Also, during a booming economy with lower credit risk, investors invest in corporate bonds rather than government bonds. Since the demand for government bonds fall, it causes their yields to rise.

Key Takeaways

• Yield spreads are dependent on maturities, credit ratings, issuer, or risk level of bonds
• Yield spreads help understand the underlying economy, sector and financial markets by expanding or contracting
• Riskier the bond, higher is its yield spread as investors have to be adequately compensated for taking higher risk
• Market interest rates have a direct impact on yield spreads

What is PEG Ratio?
The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock’s value while also factoring in the company’s expected earnings growth and is thought to provide a more complete picture than the more standard P/E ratio. The formula is:

PEG Ratio = (Price / EPS ) / EPS Growth 

EPS = Earnings Per Share

To interpret the ratio, a result of 1 or lower says the stock is either at par or undervalued based on its growth rate. If the ratio results in a number above 1, it is interpreted that the stock is overvalued relative to its growth rate. The degree to which a PEG ratio result indicates an over or undervalued stock varies also by industry and company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is desirable.

As with any ratio, the accuracy of the PEG ratio depends on the inputs used. When considering a company’s PEG ratio from a published source, it’s important to find out which growth rate was used in the calculation. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from a company’s historical growth. The ratio can be calculated using one-year, three-year, or five-year expected growth rates, for example.

Price to Earnings (P/E) Ratio vs PEG Ratio
The price to earnings (P/E) ratio is one of the simplest tools that is used to evaluate the stock of a company.  It involves taking a company’s current stock price and dividing it by the earnings per share (EPS). It shows whether a company’s stock is overvalued or undervalued. In addition, it also reveals how a stock’s valuation compares to its industry group or a benchmark. The P/E ratio helps investors determine the market value of a stock as compared to the company’s earnings.

Typically, the stocks with high P/E are considered overvalued, whereas those with low P/E are regarded as undervalued. Nevertheless, it is not always the case. Any P/E ratio needs to be considered against the backdrop of the P/E for the company’s industry.

However, P/E ratio does not factor in the company’s future growth rate which may result in erroneous conclusions while valuing a stock. Various companies grow at different rates in their life cycles. During the establishment phase, growth rates tend to be high compared with those in the maturity phase. If investors go only by the P/E ratio, the companies that grow slowly would seem attractive as their stocks would be trading at substantially lower P/E multiples. The high-growth companies, on the other hand, would appear expensive as they would trade at higher P/E multiples.

This makes PEG ratio a more suitable tool for valuation. It provides more insight into a stock’s valuation by providing a forward-looking perspective. Although PEG ratio has its own limitations where it is not applicable to real estate and airlines as these are valued on the basis of asset values, it is one of the major ratios used for valuation due to its futuristic approach and broader scope.

However, no single ratio can tell investors all they need to know about a stock. It is important to use a variety of ratios to arrive at a complete picture of a company’s financial health and its stock valuation.

Key Takeaways

• The PEG ratio is instrumental in determining a stock’s value while also factoring in the company’s expected earnings growth
• It can be calculated by dividing a stock’s P/E ratio by its EPS growth
• If the ratio is <=1, the stock is either at par or undervalued based on its growth rate. If the ratio is >1, the stock is overvalued relative to its growth rate
• P/E ratio does not factor in the company’s future growth rate which may result in erroneous conclusions while valuing a stock. Therefore, PEG ratio helps defeat this disadvantage of P/E ratio
• However, PEG ratio is not applicable to real estate and airlines as these are valued on the basis of asset values
• But PEG ratio helps give a forward-looking perspective to a stock’s valuation

 

 

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund

What is Intrinsic Value?
Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset. In financial analysis this term is used in conjunction with the work of identifying, as nearly as possible, the underlying value of a company and its cash flow.

Intrinsic value refers to some fundamental, objective value contained in an object, asset, or financial contract. If the market price is below that value it may be a good buy, and if above a good sale. There are several methods for arriving at a fair assessment of a share’s intrinsic value like dividend discount model, residual income model and discounted cash flow (DCF) model. We have discussed in detail the DCF model below:

Discounted Cash Flow (DCF) Model
The discounted cash flow (DCF) model is a commonly used valuation method to determine a company’s intrinsic value. The DCF model uses a company’s free cash flow and the weighted average cost of capital (WACC). WACC accounts for the time value of money and then discounts all its future cash flow back to the present day. It is the expected rate of return that investors want to earn that’s above the company’s cost of capital.

Using DCF analysis, we can determine a fair value for a stock based on projected future cash flows. DCF analysis looks for free cash flows—that is, cash flow where net income is added with amortization/depreciation and subtracts changes in working capital and capital expenditures. The model also estimates the future revenue streams that might be received from a project or investment in a company. Ideally, the rate of return and intrinsic value should be above the company’s cost of capital.

Why Intrinsic Value?
Analysts usually employ various methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price, allowing them to categorize it as “overvalued” or “undervalued.” Typically, when calculating a stock’s intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a ‘cushion’ between the lower market price and the price one believes it’s worth, one limits the amount of downside that would incur if the stock ends up being worth less than the estimate.

While calculating intrinsic value may not be a guaranteed way of mitigating all losses to the portfolio, it does provide a clearer indication of a company’s financial health, which is vital when picking stocks intended to be held for the long-term. Moreover, picking stocks with market prices below their intrinsic value can also help in saving money when building a portfolio. Although a stock may be climbing in price in one period, if it appears overvalued, it may be best to wait until the market brings it down to below its intrinsic value to realize a bargain.

For a beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provides a sobering perspective on the price of its shares.

Key Takeaways

• Intrinsic Value is the measure of the worth of an asset calculated by several methods
• A share’s intrinsic value can be calculated using methods like dividend discount model, residual income model and discounted cash flow (DCF) model
• Intrinsic Value is important to determine if a security is “overvalued” or “undervalued” if compared to the market price
• It is also important to determine an appropriate margin of safety by keeping a cushion between the lowest market price and intrinsic value
• This helps limit the amount of downside that would incur if the stock ends up being worth less than the estimated intrinsic value
• Intrinsic Value helps provide a clearer indication of a company’s financial health, which is vital when picking stocks intended to be held for the long-term

 

 

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund

What is Duration?

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond’s duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand is non-linear and accelerates as time to maturity lessens.

There are two types of duration: Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows, and should not be confused with its maturity. Modified duration measures the price change in a bond given a 1% change in interest rates. A fixed income portfolio’s duration is computed as the weighted average of individual bond durations held in the portfolio.

Understanding Duration
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. At the same time, duration is a measure of sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. In general, the higher the duration, the more a bond’s price will drop as interest rates rise (and the greater the interest rate risk).

The factors affecting a bond’s duration are:

• Time to Maturity: The longer the maturity, the higher the duration, and the greater the interest rate risk. A bond that matures faster—say, in one year—would repay its true cost faster than a bond that matures in 10 years. Consequently, the shorter-maturity bond would have a lower duration and less risk.
• Coupon Rate: A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower coupon rate. The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

 

Long and Short Duration Strategies
A long-duration strategy describes an investing approach where a bond investor focuses on bonds with a high duration value. In this situation, an investor is likely buying bonds with a long time before maturity and greater exposure to interest rate risks. A long-duration strategy works well when interest rates are falling, which usually happens during recessions.

A short-duration strategy is one where a fixed-income or bond investor is focused on buying bonds with a small duration. This usually means the investor is focused on bonds with a small amount of time to maturity. A strategy like this would be employed when investors think interest rates will rise or when they are very uncertain about interest rates and want to reduce their risk.

What is Accrual Strategy?
An accrual strategy aims to primarily earn regular interest income from the investment made and ideally seeks to hold the paper until it matures, other things remaining the same. Funds that use this strategy are also called ‘income’ funds as their primary strategy is to receive regular income from the papers they hold.

An accrual strategy is typically adopted by fund managers in instruments with short to medium term maturity. This is because of three reasons:

• Locking in very long-term interest rates is advisable when they are the highest
• Locking for the long term, other than in government securities, could spell unforeseen credit risk in future
• Long term exposes the papers to interest rate vagaries and hence more prone to volatility. They do not thus make for predictable returns

 

What is an Accrual Bond?
An accrual bond’s interest is added to the principal balance of the bond and is either paid at maturity or, at some later date, when the bond begins to pay both principal and interest based on the accrued principal and interest to that point.

A traditional bond involves making periodic interest payments to bondholders in the form of coupons. The interest is paid at scheduled dates until the bond expires, at which point, the principal investment is repaid to the bondholders. However, not all bonds make scheduled coupon payments. One such bond is the accrual bond.

An accrual bond defers interest, usually until the bond matures. This means interest is added to the principal and subsequent interest calculations are on the growing principal. In other words, the interest due on the accrual bond in each period accretes and is added to the existing principal balance of the bond due for payment at a later date.

Why Accrual Strategy?
Accrual strategy has the following advantages:

• Predictability: As interest income keeps adding to the NAV steadily, there is predictability of returns. For most overnight and liquid funds, if the residual maturity (average remaining tenure of the underlying papers) is known and YTM while investing, a fair idea of return can be expected over that residual maturity.
• Less Volatility: There is less volatility in accrual funds primarily because they are of very short or medium duration. As shorter duration instruments are less sensitive to interest rate moves than longer duration papers, the investor will experience less swings in the fund’s NAV.

 

Categories of Accrual Strategy in Mutual Funds
The following are the categories of accrual strategy in mutual funds:

• Liquid category: In the liquid category features the overnight funds and liquid funds in which the average maturity doesn’t exceed 90 days. They have the lowest risk interest rate risk and are suitable for parking of surplus funds for a very short period of time.
• Liquid plus category: In this category features ultra-short duration funds, low duration funds and money market funds. In these funds, the average maturities range from 3 to 12 months depending on the sub-category. These too are suitable for short term parking of funds as they have low interest rate risk and thus experience less volatility.
• Others: The other sub-categories that feature here are corporate bond funds, banking and PSU debt funds and credit risk funds. These funds have higher maturities, usually more than 2 years and thus can be more volatile compared to the liquid and liquid plus categories with respect to interest rate risk. However, credit risk funds carry credit default risk which an investor should be aware of.

 

Accrual funds are not entirely immune to the effects of rising interest rates, especially when the rise is steep and fast, but the impact is far lower than on duration funds.

Key Takeaways

• Duration helps understand the relation of bond prices to the change in market interest rates
• The longer the maturity, higher is the duration of the bond. Conversely, higher the coupon rate, lower is the duration of the bond
• A long-duration strategy works well when interest rates are falling, and a short duration strategy is more suitable when interest rates are expected to rise
• Accrual strategy is to earn regular interest on the bonds and are ideally to be held till maturity
• An accrual bond’s interest is added to the principal balance of the bond and is either paid at maturity or, at some later date
• Accrual strategy offers predictability due to the regular interest income and is less volatile as such funds are of very short or medium duration

 

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund