Investment options:

Various options available are described in the following paragraphs and evaluated broadly on criteria such as

• Liquidity

• Safety

• Return

• Tax savings

• Active involvement required to manage the investment

• Minimum amount that can be investe

Primary market refers to new issues of shares by new companies as well as existing companies. Apart from shares, other instruments commonly issued in the primary market are debentures, convertible debentures, shares with attached options like warrants, etc.

Secondary market refers to the stock exchanges where an investor can buy (or sell) shares which are listed on them. India’s stock market has been dominated by equity shares. As a result of significant changes in the recent past, particularly computerisation, online trading, dematerialisation and depository participation, investors are now dealing with a much more transparent and efficient secondary markets.

Equity Shares yield returns in two ways: one, dividends declared by companies usually at the end of a year (and sometimes during the course of the year) and, two, capital gains on sale of Equity Shares.

Liquidity of investment in equity shares depends upon the trading volumes of the share. If the share is actively traded, an investor can easily sell the shares and realise the sale proceeds. However, if the share is not traded (or is delisted), then liquidity is a constraint. Technically, it is possible to buy even single shares in dematerialised securities regime and also to buy small lots of 50 to 100 shares so as to keep the investment amount low.

Equity shares are primarily volatile instruments. Equity share is an appropriate investment avenue for an investor who is not risk averse. Such an investor is prepared to take risks in order to generate higher returns. Returns from equity shares at aggregated levels have been historically higher than most other avenues over the long term. However, individual investors could gain or lose depending on the companies’ shares they invest in. An investor needs to be aware of the companies and their performances. Company performance should be monitored closely in order to track the investment performance. An investor should also have some basic knowledge of financials and of market systems in order to manage equity investments. The trends in equity market are reflected in the movement of the equity indices and the volume of the trading activity.

Debt instruments represent contracts where one party is the lender (investor) and the other party is the borrower (issuer). The debt contract specifies the rate of interest, time of interest payment, repayment of principal, etc. In India, the term "bond" is used to represent the debt instrument issued by the central and state governments and PSUs. The term "debenture" is used to mean debt issues from the private corporate sector. The principal features of a debt instrument are:

• Maturity

• Coupon

• Principal

Maturity refers to the date on which the principal would be repaid. Coupon is the rate at which interest is calculated with reference to the face value. For example, a 10% 2010 bond refers to face value of Rs. 100, coupon rate of 10% p.a.. and repayment of the face value in the year 2010.

The coupon rate may be fixed for the entire perod or may be related to a benchmark rate. In the latter case, the coupon rate changes as the benchmark rate changes. This instrument is called a floating rate debt instrument.

There are debt instruments that come with options to redeem the principal earlier than the maturity date. If the option rests with the issuer, it is a bond that is callable. If the option to redeem rests with the investor, it is puttable.

There are many different types of debt instruments in India. These are

• PSU bonds

• Government securities

• Treasury bills

• State loans

• Corporate debentures

• Bonds from financial institutions

• Commercial papers

• Certificates of deposits

The secondary market activity for debt instruments takes place in the debt segment of the exchange. The trends in the debt market are reflected in the debt indices and the turnover data. In India, the debt market activity is dominated by banks and institutions.

A Bond is a loan given by the buyer to the issuer of the instrument. Bonds may be issued by companies, financial institutions, or the government. Over and above the scheduled interest payments as and when applicable, the holder of a bond is entitled to receive the par value of the instrument at the specified maturity date.

Bonds can be broadly classified into

1. Tax-Saving Bonds and

2. Regular Income Bonds

Tax-Saving Bonds offer tax exemption up to a specified amount of investment. Examples are:

1. ICICI Infrastructure Bonds under Section 88 of the Income Tax Act, 1961

2. NABARD/ NHAI/REC Bonds under Section 54EC of the Income Tax Act, 1961

3. RBI Tax Relief Bonds

Regular-Income Bonds, as the name suggests, are meant to provide a stable source of income at regular, pre-determined intervals.

Similar instruments issued by companies are called debentures. Bonds are usually not suitable to achieve capital appreciation. Sometimes, an investor buys bonds at a lower price just before a decline in interest rates, and the subsequent drop in the interest rates leads to an increase in the price of the bond, thereby facilitating capital appreciation.

Bonds are suitable for regular income purposes. Depending on the type of bond, an investor may receive interest semi-annually or even monthly, as is the case with monthly-income bonds. Depending on one's capacity to bear risk, one can opt for bonds issued by top-ranking corporates, or that of companies with lower credit ratings. Usually top ranking corporates offer lower interest on bonds as compared to companies with lower credit ratings

Debentures are debt instruments. Companies borrow from debenture-holders and generally offer a fixed rate of interest to such investors. Most debentures are redeemed after a specified period. The period could be short (less than 18 months) or long depending on the terms of issue. In some cases, companies also pay a premium on maturity.

Investors can subscribe to public issue of debentures by companies or buy debentures from the secondary market. In view of the fixed returns from these securities, prices of debentures are generally much less volatile relative to shares. Investors earn interest and capital gain (difference between the purchase price and the sale price or if held till redemption, the difference between purchase price and the redemption price).

Yields on debentures could be higher or lower than the specified rate of interest depending on the correlation between face value and market value. For example, assume that a Rs 100 debenture carrying 15% interest is bought for Rs 90. The price paid is Rs. 90 whereas the interest earned is Rs. 15. This would translate to a yield of 16.67%.

In the above example, the investor would get back Rs 100 from the company (face value) if he holds the debentures up to maturity. Hence, apart from the interest yield of 16.67%, he would also gain Rs 10 by way of capital gain. When this capital gain is also considered for computing the yield, it is termed as Yield to Maturity (YTM). A detailed illustration for calculation of YTM is provided in the appendix to this chapter.

Liquidity in debentures is unfortunately low in the Indian markets in view of the lack of interest in these instruments so far. Very few debentures are actively traded on stock exchanges. Most debt issues are required to be rated by credit rating agencies. Rating indicates the quality of the instrument. An indication of credit rating is given below:

Different rating agencies might have different symbols then the ones given above.

Returns from high quality debentures are steady and can be ascertained in advance based on the YTM. These returns would vary only if the company were to renege on its payment obligations. An investor need not be actively involved in investment management, except to the extent of keeping basic track of companies, which might be performing badly and could fail to fulfill its interest or repayment obligations.

Debenture prices are dependent on the face value of these instruments. The most common face value is Rs 100. Hence, even small amounts of Rs 10,000 can be invested in debentures.

Various bonds are floated from time to time by public sector undertakings as well as Development Financial Institutions. Most bonds offer attractive schemes like monthly interest, quarterly interest, various redemption options, deep discount bond options, etc.

A deep discount bond is a long-term bond where the initial amount invested keeps growing based on the interest accumulated on the principal amount. For example, an investment of Rs 2,800 today could yield Rs 1,00,000 after 30 years.

Bond prices are dependent on the face value of these instruments. The most common face value is Rs 100. Minimum amounts are generally around Rs 5,000. An investor need not be actively involved in investment management.

RBI Tax Free Bonds are special bonds issued by the RBI offering tax-free facility. The rate of interest in such bonds is generally lower than regular bonds (around 8.5%) and hence will attract only high taxpayers. These bonds tend to be long-term instruments.

RBI Tax free bonds are very safe as they come from the country’s central bank. Returns from the bonds are steady and can be ascertained clearly in advance based on the YTM. For an original subscriber, 8.5% tax free return would work out to over 12% pre-tax, assuming the highest tax rate of 30%.