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Over the next couple of weeks, we’ll explore the money markets and bond markets. There’s a lot to cover in this topic! Let’s start with some terms and concepts used in the fixed income space. Reference for this post is ‘An Introduction to Global Financial Markets’ by Stephen Valdez.

The Rate of Interest

So far, we’ve talked casually of the rate of interest for borrowing and lending. Of course, there’s more to it that that…for one, the rate of interest is not fixed, it differs for different borrowers. Naturally, the rate of interest of borrowing for the government might be less than that for private companies. Additionally, the rate changed for a short term loan might be lesser than a loan of a long duration.

Risk

Put quite simply, a lender will feel more confident lending to a government than to a private company. After all, the government is unlikely to default on its payment (though it has been known to happen!). Thus, the government rate becomes the benchmark rate for other companies. For example, an American corporate wishing to borrow for say, 3 months, may be expected to pay ‘Treasuries plus 1%’ meaning 1% more than the current rate for US government Treasury bills. You might also here this referred to as ‘Treasuries plus 90 bps’. What does bps mean? Bps stands for basis points and a basis point is 1/100 of a percentage point. Therefore, 50bps = 0.5%. The difference between any given rate and the benchmark US government rate will be called the spread or ‘the spread over Treasuries’.

Maturity

Theoretically speaking, lenders will expect a higher rate of interest for lending money for 5 years than for 3 months. This relationship between the rate of interest and time is called the yield curve.

Yield

Yield is a very important term in finance. Yield is the return on investment expressed as an annual percentage. We’ll get back to what yield is after tackling some related concepts.

Par/Nominal Value

Bonds have a par or nominal value. This is the principal amount on which the rate of interest is based and which will be repaid at maturity. Let’s take an example. You buy a bond with a par value of $100 with a maturity of 10 years and interest rate of 10%. You would think the yield on this bond would be 10%, right? You would be right only if you don’t consider the secondary market in this picture.

Suppose, 2 years later you decide to sell the bond as you need some money. However, the interest rate has changed in the interim. Now the interest rate for similar governments bonds is 12.5%. When you try to sell your bond with 10% interest rate in the market, no one would be willing to pay $100 for it, when they can get the same bond in the market with a higher return. They might be willing to pay you $80 because your bond pays $10 per year (10% interest) and $10 is 12.5% of $80 giving a comparable yield to that available in the market. The market price of your bond is less than the par value you paid for it to give the desired yield of 12.5%. So, when interest rates went up, the price of your bond went down.

Say you didn’t sell your bond then and now, two more years down the road are thinking of selling it. However, now things have changed again and the current interest rate for similar bonds is 8%. You will have no shortage of buyers now because 10% is very attractive if the market rate is 8%. The market price of your bond is more than the par value you paid for it to give a yield of 8%. So, as interest rates went down, the price of your bond went up.

Interest Yield

In the above examples, we have calculated what is known as Interest Yield. Quite simply, it is the interest amount (coupon)/price of the bond. Interest yield is also known as simple, flat, running and annual yield. This is a good metric but not very useful.

Gross Redemption Yield

Unfortunately, in our above examples and calculations, we omitted one crucial factor – redemption. In the first example above, when the current market interest rate is 12.5%, an investor can do one of these two things –

• Buy the new government bond at 12.5% buy paying $100 par value – interest yield 12.5%
• Buy the existing 10% bond for $80 price – interest yield 12.5%

What we forgot, is that when the bond is redeemed at the end of 10 years, the government will pay $100 back. In case 1 above, there is no capital gain as the initial investment is also $100. In case 2, there is a capital gain of $20. This means we need a more comprehensive calculation that not only includes the interest yield but also the capital gain or loss at redemption. This is the Gross Redemption Yield or Yield to Maturity. The formula to calculate this is quite complication so we won’t go into that here. We are taking the future stream of revenue – interest and redemption – and calculating the yield that would equate this value to the bond’s current price. Alternatively, we could start with a desired yield and calculate the price of the bond that would achieve that yield. This is how bond dealers calculate the price of bonds which is why yield is so important.

Credit Ratings

We said the lower the amount of risk associated with a borrower, the lower her rate of interest will be. This is said to reflect the creditworthiness of the borrower, meaning she is unlikely to default. Some markets (for instance, the US) want the creditworthiness of the borrower to be officially assigned a credit rating that will help guide investors in their decisions. There are several companies in the ratings business with the most important being – Standard & Poor’s and Moody’s. The S&P Ratings go from AAA to D. A bond rated ‘D’ is either already in default of is expected to default soon.  Bonds above BBB rating are of top quality – investment grade. Bond below BB rating are called junk bonds.

Stay tuned for more…

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• The Fed May Decide To Engineer A Major Sell-Off In The Bond Market When It Exits
• Bangladesh confirms dollar bond plan

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Does money grow on trees? Yes, it does. That is what my parents thought when they invested Rs 600 in my name in a collective investment scheme floated by Esskayjay Plantations Ltd in August 1992. With its slogan “Money does grow on trees”, the company promised that “Rs 600 will grow over Rs 1,00,000 on tree in just 20 years”.

Fast forward to 2013, when time came to reap the benefits of our investments, we realised that the company had gone bust.  Repeated queries at the company’s registered address in Kolkata yielded no response. Last heard about the dubious firm is that market regulator Sebi has initiated prosecution proceedings against Esskayjay Plantations Ltd and its promoters for violation of Sebi’s  (Collective Investments Scheme) Regulations, 1999.

The plight of gullible depositors of Sharadha Group is not surprising as many of us have been victims of Ponzi schemes, chit funds, illegal multi-level marketing , etc. The modus operandi of all the schemes is different from each other. While debate is on whether Saradha Group’s schemes can be labelled under the chit fund category, the spotlight is back on chit funds.

Widely popular in hinterland, chit fund is a vehicle for savings and borrowings and provides easy credit to meet your urgent fund requirements like marriage, health, education expenses, etc.

While households dabble in chit funds mainly to save cash on a daily basis to meet future needs, small traders and businessmen are big players in the industry as it offers them access to easy finance apart from saving their excess cash.

RBI defines chit funds as “when a company enters into an agreement with a specified number of subscribers that every one of them shall subscribe a certain sum in instalments over a definite period and that every one of such subscribers shall in turn, as determined by tender or in such manner as may be provided for in the arrangement, be entitled to the prize amount.”

To elaborate on the business model- assuming that 20 depositors agree to pool in an amount of Rs 2,000 for 20 months i.e. for a total chit value of Rs.40,000/-, each depositor will get his chit amount when his turn comes by draw of lot or by auction.

During auction every month, the chit amount is given to the bidder who bids for the highest amount, not exceeding the maximum limit.

The amount, foregone by the subscriber is distributed as dividend amongst all the subscribers in every draw, after deducting 5% commission to be paid to the company or agents. 40% is the maximum bid allowed and the duration of chit is normally between 12 months to 50 months.

Suppose the winning bidder bids for Rs 25,000, he would get this amount and, the rest of the amount i.e. Rs. 15,000 is divided among the 20 depositors. This discount of Rs. 750 (i.e. 15000/20) is then returned back to each member. So the next month’s contribution would be Rs. 1250 (Rs. 2000- Rs. 750). The member winning the “prize money” must continue making payments each month but can no longer participate in the auction.

According to the All India Association of Chit Funds, there are about 10,000 Chit Funds registered in India with annual subscription of Rs 30,000 crore per annum and bulk of them operate in Tier II and Tier III towns. What explains this flourishing financial market that offers sky-high returns only to vanish?

Chit funds tapped into segments that banking channels thought was not lucrative. Lack of access to banking services and post office branches for investing their daily savings forced poor people to turn to their neighbourhood chit fund. Also, strong backing from local politicians, as evident in the Sharadha scam, allowed them to operate unhindered.

But it would be wrong to paint the entire chit fund industry as sham. Registered funds are regulated by the Chit Funds Act, 1982 under the control of state governments. Despite the industry’s history of scams and collapses, many genuine companies like Shriram Chits and others offer saving and borrowing options for the unbanked rural people and small businesses, thus furthering the cause of financial inclusion.

Since many chit funds have deeply penetrated into rural markets, only increased regulation can weed out fraudsters like Sharadha group. With state governments woefully ill-equipped to administer chit funds, it is time to bring chit-funds under the purview of Securities and Exchange Board of India (Sebi). On its part, the market watchdog needs to strengthen its monitoring mechanisms at the grassroot level to protect poor people from investment crooks.

Related articles

• Different schemes built on different structures
• Money lessons from the Saradha scam
• 60 firms like Saradha operating in Bengal
• The Anatomy of a Ponzi Scheme

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A Ponzi scheme is an operation that pays returns to it’s investors from either the investors own money or money paid into the operation by subsequent investors. The word “Ponzi” refers to Charles Ponzi, who, in the 1920s, promised clients a 50% profit within 45 days, or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeeming them at face value in the United States as a form of arbitrage. In reality, Ponzi was paying early investors using the investments of later investors.

Ponzi schemes are doomed because their funding requirements increase geometrically over time. So there are not too many exit strategies for the person running a Ponzi scheme. It always ends ugly. However, that doesn’t mean that people don’t try. In 2009, 20% of the fraud cases investigated by the U.S. Securities and Exchange Commission (SEC) were Ponzi schemes.

Next, we see how chit-funds operate and how they are just a tiny step away from being Ponzi schemes.

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• Working hard to save investors from Ponzi schemes: SEBI
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