Challenge Pathway -Prep Book

["Distressed assets tend to show little correlation with either equity or debt markets and attendant risks including market risk. This asset class can be a good diversifier for the portfolio. In case of a company which files for bankruptcy, a number of resolution plans get submitted to NCLT involving big companies looking to strategically acquire large stressed assets at substantial discounts to their market prices. Small Savings Schemes and Instruments with Sovereign Guarantee Public Provident Fund The Public Provident Fund (PPF) scheme was instituted by the Public Provident Fund Act, 1968 to provide an investment avenue to the general public. There is sovereign guarantee to all subscriptions and interest accrued or credited to PPF accounts. The amount standing to the credit of any subscriber in the PPF account shall not be liable to attachment under any decree or order of any court in respect of any debt or liability incurred by the subscriber. The government via a notification dated December 12, 2019 replaced the Public Provident Fund Scheme, 1968 with Public Provident Fund Scheme, 2019. The account can be opened and operated at a post office or any public sector bank or select private sector banks. The online facility is also available in certain banks to open and operate a PPF account. A person can open only one PPF account. However, a person can contribute subscriptions to accounts opened in the name of minor children, or other minor\/s for whom she\/he is legal guardian, as well as in the name of spouse. There is no age limit prescribed for opening a PPF account. The subscription to a PPF account can be made up to the maximum limit prescribed (currently Rs 1,50,000) in a financial year. Subscription can be made in lump sum or in any number of instalments during a financial year. The minimum amount per instalment, as also the minimum subscription required in a financial year to keep the account in operation, is Rs 500. There is deduction from income available for PPF subscription up to a maximum limit of Rs 1,50,000 in a financial year under section 80C of the Income-tax Act, 1961. This subscription limit of Rs 1,50,000 as well as the tax incentive is available across all contributions made under a single PAN by an individual in a financial year. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 197","The PPF account cannot be opened in joint names. A nomination can be made. A PPF account cannot be opened by a Hindu Undivided Family (HUF). It can neither be opened nor operated by a power of attorney holder. It cannot be opened by a non-Resident Indian (NRI). However, an NRI is allowed to continue investing in his\/her PPF account, which was opened while he\/she was a Resident of India, but only till the account\u2019s initial maturity. The account in such cases cannot be extended. The NRI however has the option to prematurely close the account after 5 financial years from the end date of the financial year in which the account was opened. In case of premature closure, the account will earn 1% less interest than the prescribed PPF interest rate per financial year. PPF account in unique in the sense that it is Exempt-Exempt-Exempt. The subscriptions made in a financial year (up to the limit prescribed) have tax incentives; the interest earned during a year on subscriptions is not added to income of that year and not made taxable; and the accumulated amount on maturity of the account is not subject to any kind of tax. The government by a notification can change the interest rate on PPF account balances as applicable effective a calendar quarter in a financial year. For the quarter June- Sept, 2021, the interest rate for PPF is 7.1%. The interest is accrued on monthly basis on the minimum monthly balance outstanding in account between the 5th day and the last day of a month, and is credited to the account on 31st March of a financial year. PPF account is for an initial term of 15 years, which is counted from the end of the financial year in which the account is opened. For instance, an account opened on 3rd May, 2020 shall have first financial year ending on 31st March 2021. The account will mature on 1st April, 2036. Therefore, if annual subscriptions are only made in each financial year in a PPF account right up to its initial maturity, it can take 16 subscriptions. A PPF account can be extended after its initial maturity for a 5- year block, there being no limit on the number of such extensions back-to-back. Such extension terms can be with or without subscription. If an option is not exercised within a year after the initial maturity of an account, it is deemed to be extended without subscription. In cases of extension without subscription, any amount outstanding in the account can be withdrawn by the subscriber, but only once during a financial year. The account will continue to normally earn PPF interest. In case of extension with subscription, the withdrawal rule is 60% of the amount outstanding prior to the extension being granted, but only once in a financial year during the 5- year extension block. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 198","The PPF account offers loan facility which is available from the 3rd financial year (from the financial year in which the account is opened) up to the end of 6th financial year. The loan amount can be a maximum of 25% of the amount outstanding at the end of the 2nd year immediately preceding the loan application year. The loan has to be repaid in 36 equal monthly instalments at a nominal interest rate which is 1% p.a. of the loan amount. However, if the loan is not repaid within the prescribed 36- month period, the rate goes up to 6% p.a. The interest on loan is payable in maximum 2 instalments after the full repayment of loan. The entire loan amount does not earn any interest until the loan is repaid. Only the balance amount in the PPF account will earn interest. Thus, effectively the rate of loan against a PPF account is 1% plus the PPF rate. A partial withdrawal from the PPF account is permissible. However, such partial withdrawals can be made from the 7th financial year (end of the six years from the end date of financial year in which the account is opened). The admissible partial withdrawal is equal to 50% of the amount that stood in the account at the end of 4th year preceding the year in which the amount is withdrawn or the end of the preceding year whichever is lower. Sukanya Samriddhi Yojana The Sukanya Samriddhi Yojana was notified by a Central Government gazette notification dated 2nd December 2014. The Sukanya Samriddhi account may be opened by the natural or legal guardian in the name of a girl child from the birth of the girl child till she attains the age of 10 years. Only one account can be opened in the name of a girl child in Post Office and branches of authorized banks. Natural or legal guardian of a girl child shall be allowed to open the account for two girl children only, provided if the second childbirth results in twin girls, or the first childbirth itself results in three girls, the account can be opened for three girl children. The account can be opened with a minimum of Rs. 250 and thereafter any amount in multiple of Rs. 100 can be deposited any number of times in a year up to a maximum of Rs. 1.50 lakh per account in a financial year. A minimum of Rs. 250 must be deposited in a financial year to sustain the account. Benefit under section 80C of the Income-tax Act, 1961 is available to a depositor (guardian of girl child\/ren). International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 199","On attaining age of 10 years, the account holder, that is the girl child, may operate the account herself, while deposit in the account may be made by the guardian or any other person or authority. Deposits in an account may be made till completion of 14 years from the date of opening of the account. The account can be closed prematurely only in case of death of the account holder girl child, or only in cases of extreme compassionate ground such as medical support in life- threatening diseases, or where the Central Government is satisfied that operation or continuation of the account is causing undue hardship to the account holder. The Sukanya Samriddhi account shall mature on completion of 21 years from the date of opening of account or on the marriage of account holder whichever is earlier. However, one withdrawal shall be allowed on attaining the age of 18 years of account holder girl child to meet education expenses up to 50 % of the balance at the credit of preceding financial year. The interest rate on Sukanya Samriddhi accounts for the quarter June- Sept, 2021 is 7.6% p.a., the interest is credited at the end of a financial year and is compounded on annual basis. National Savings Certificates The National Savings Certificates rules were notified on 8th May, 1989 by the Central Government in exercise of the powers conferred by section 12 of the Government Savings Certificates Act, 1959. All individuals, joint individuals and minors (supported by guardians) can invest in the certificates in multiples of Rs 100; the denominations available for investment are of Rs. 100, Rs. 500, Rs.1,000, Rs.5,000, Rs.10,000 and such other denominations as may be notified by the Central Government from time to time. There is no upper limit for investment. Hindu Undivided Families (HUFs), Non-resident Indians (NRIs), trusts and companies cannot invest in NSC-VIII series. However, a resident who subsequently becomes NRI during the currency of the period of a certificate, shall be allowed to avail the benefits of the certificate on maturity on a non- repatriation basis. There are Single Holder Type certificates, issued to an adult for himself\/herself or on behalf of a minor, or to a minor. A Joint \u2018A\u2019 Type Certificate may be issued jointly to two adults payable to both the holders jointly or to the survivor, while a Joint \u2018B\u2019 Type Certificate may be issued jointly to two adults payable to either of the holders or to the survivor. The Aadhaar number shall be the unique identifier for the purpose of International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 200","establishing the identity of an account holder. The nomination can be made by adult holders, single or joint. The nominee, after death of certificate holder, shall be able to encash the certificate any time prior to or after the maturity of the certificate, or apply to sub-divide the certificate in appropriate denominations in favour of individual nominee or two adult nominees jointly. The NSC-VIII series certificates are issued by post offices, public sector banks and select private sector banks. A certificate may be transferred from a post office at which it stands registered, to any other post office on the holder\/holders making an application in the prescribed form at either of the two post offices. Kisan Vikas Patra The Kisan Vikas Patra (KVP), a saving instrument for individual savers distributed through post offices, was launched by the Central Government on 1st April, 1988. The unique feature of this scheme is to double the money invested in a certain period. The operating features of KVP mostly correspond with those of NSC-VIII series certificates with respect to eligible investors, holding basis, nomination, transfer and pledge. It is also issued in electronic form with effect from 1st July, 2016. A KVP certificate has a serial number, the denomination, the maturity date and the amount to be received on the date of maturity. The minimum investment is Rs. 1,000 and in multiples of Rs. 100 thereafter, there being no upper limit to the investment. The denominations of Rs. 5,000 and Rs. 10,000 are also available. The government, in order to prevent money laundering, mandated in 2014, PAN card as necessary document for KVP investments in excess of Rs. 50,000. For investments exceeding Rs. 10 lakh in KVPs, one needs to also submit evidence of income. It is now also mandatory to submit Aadhaar number towards proof of identity. KVP is not eligible for tax benefits. The interest rate applicable on accounts opened during the quarter June-Sept, 2021 is 6.9% p.a. Thus, KVPs can be purchased with a doubling period of 124 months. There is no tax deduction at source from maturity proceeds. KVP certificate can be used as collateral or security to avail secured loans. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 201","Post Office Monthly Income Scheme The Post Office Monthly Income Scheme (POMIS) is a saving product for individuals singly, and jointly up to three individuals, and for minors above 10 years of age. Minor after attaining majority has to apply for conversion of the account in his\/her name. The maximum amount that can be invested by an individual is Rs. 4.5 lakh. However, joint accounts are capped at Rs. 9 lakh. The share of an individual cannot exceed Rs. 4.5 lakh including his\/her share in joint account. Each joint holder has an equal share in a joint account. Single account can be converted into joint and vice versa. Any number of accounts can be opened in any post office subject to aggregate investment limited to Rs. 4.5 Lakh across all such accounts. The tenure of the scheme is 5 years from the date of opening the account with a post office. The interest rate as on 1st July, 2021 is 6.6% p.a. The account can be closed prematurely but after a lock-in period of one year. The premature closure of account before 3 years attracts a deduction of 2% of the deposit amount. The same is 1% of the deposit amount after completion of 3 years from the date of opening of the account. Senior Citizens Savings Scheme The Senior Citizens Savings Scheme (SCSS) can be applied by a resident individual of age 60 years or more in post offices as well as authorized commercial banks across India. Individuals of age 55 years or more who retire on superannuation or under an approved voluntary retirement scheme can also open a SCSS account, provided the account is opened within one month of receipt of retirement benefits and the amount sought to be deposited in the account is not in excess of such retirement benefits received. A retired person of Defense Services can open an SCSS account on completing 50 years of age. HUFs and NRIs are not allowed to invest in this scheme. The maximum amount that an individual can deposit in the account is Rs. 15 lakh (in multiples of Rs. 1,000). This maximum amount can be across multiple accounts in many post offices, either holding individually or jointly with spouse. The joint account can be opened with spouse only, provided the first holder in a joint account is the investor himself\/herself. However, it is possible that two separate International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 202","accounts can be opened by an individual and spouse, each with a maximum limit of Rs. 15 lakh. Thus, an individual and spouse can invest cumulatively Rs. 30 lakh in SCSS accounts. The Rs. 15 lakh in each account can be invested jointly as well; one account where the individual is first holder, and the second where his\/her spouse is first holder. The account has tenure of 5 years. It can be extended for a further term of 3 years but by due application within a year from the date of initial maturity. The amount of interest received under SCSS is taxable at individual\u2019s slab rate. TDS is deducted at source on interest if the interest amount is more than Rs 50,000 in a financial year. Tax benefit of up to Rs.1.5 lakh amount deposited can be claimed under Section 80C of the Income-tax Act, 1961. There is strict penalty if the account is closed within a year from the date of opening, where the interest for the period of deposit is not paid, and if already paid in some quarter\/s, is recovered from the deposit amount. The penalty as a percentage of deposit amount is 1.5% after a lapse of one year and 1% after 2 years from the date of opening of the account. Sovereign Gold Bonds The Sovereign Gold Bonds (SGBs) are issued by the Reserve Bank of India on behalf of the Government of India. As the name suggests, they carry sovereign guarantee both on the redemption amount and on the interest payable. SGBs are substitutes for holding physical gold. The eligible investors are individuals, HUFs, trusts, universities and charitable institutions. Individual investors with subsequent change in residential status from resident to non-resident may continue to hold SGBs till early redemption\/maturity. Joint holding and holding on behalf of minors are allowed. SGBs are issued in denominations of one gram of gold and in multiples thereof. Minimum investment is one gram, and maximum is 4 kg for individuals\/HUFs and 20 kg for trusts and similar entities. This annual ceiling will include bonds subscribed under different tranches during initial issuance and those purchased from the secondary market. The SGBs can be applied online on issuance and can be held in electronic form in Demat accounts. They are tradable, and can be bought in the secondary market as well. The issue price is linked to the International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 203","average of 3 days\u2019 price of gold of 0.999 purity (24 carat) published by India Bullion and Jewelers Association Ltd. (IBJA). Generally, a discount of Rs. 50 is offered per gram price of such gold on the issue price (nominal value) so fixed on the series when issued by RBI. The interest at 2.5% p.a. is paid on the nominal value of SGB, payable on half-yearly intervals. The interest is credited semi-annually to the investor's linked bank account. The investment in SGBs has several advantages over other forms of investment, such as coins\/bars, bullion, jewelry or through Gold ETFs. The price linked to the highest purity of gold is assured. There are no costs on holding (e.g. administrative fees on Gold ETFs), or storage (e.g. locker charges for keeping safe custody of coins\/bars, bullion, jewelry). SGBs carry 2.5% interest. There is \u2018nil\u2019 capital gains in case they are held to maturity, against 20% long-term capital gains tax (for holding period above 3 years) in case of physical holding and Gold ETFs. SGBs can be easily used as collateral for loans which is not available in case of Gold ETFs, while other form of physical gold may require expensive value assessment. The sovereign guarantee, ease of holding and disposal, tradability are other obvious advantages of investing through SGB. Investing in Fixed Income Securities The fixed-income instrument market is typically very large world over in comparison to other instruments such as equity. They play a critical role in financing the governments as well as large corporate. The debt instruments play a critical role in determining the supply of money in the market and are used by the central banks in their monetary policy determinations. The debt instruments are variously affected by the interest rate risk in the economy and other specifically related risks such as credit risk of the issuers. They cumulatively present a formidable asset class to diversify portfolios and address liquidity and income flows. For raising capital, there are broadly two categories of instruments: equity and debt. We shall ignore hybrid instruments in this discussion, for the sake of simplicity. Corporates use both equity and debt, depending on their preference, cost, etc. Government however, issues bonds only, as there is no concept of \u201cGovernment equity\u201d. When Government and corporates or other Issuers issue bonds or other instruments, that comes in the domain of debt capital markets (DCM). In this chapter, we shall International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 204","discuss the profile of the debt capital market in India and the role it plays as a source of funds for Government and Corporates. Sovereign: the Union Government is referred to as sovereign. This is the best credit-quality Issuer with zero or near-zero credit risk. The safety aspect emanates from the supreme nature of the Issuer: the Government can impose taxes and the Reserve Bank of India (RBI) being part of the machinery, can influence currency management as well. Next to the Union Government is the various State Governments. The instruments issued by the State Governments, called State Development Loans (SDLs), are quasi-sovereign. The public sector comprises Central PSUs, State PSUs, Banks, Financial Institutions and municipal corporations. The distinction between Government as an Issuer and a public sector entity as an Issuer, from the debt market perspective is that in a PSU the financial strength and the extent of ownership by the Government are relevant to gauge the safety or credit risk aspect. For the Government per se as an Issuer, it is the ownership only (i.e. sovereign); otherwise they run on deficits - a fact considered irrelevant by debt market participants. Private sector comprises corporates, Banks, NBFCs etc. From the debt market perspective, the fundamental strength of the Issuer is relevant as that defines the probability of getting back your money. The credit rating is taken as a proxy for the credit quality of the instrument by investors; evolved institutional investors have the bandwidth to do their own research. The requirement for mobilization by the various Issuers mentioned above is broadly of two types: (a) for the Governments it is to fund the deficit as their budgets perennially run on deficits and (b) for corporates in private sector and PSUs it is to fund either growth (capital expenditure) or for working capital purposes. The Central Government is the largest Issuer of bonds in India and has a singular role. The State Governments also have a singular role as Issuer. Banks are the largest investor in Government Securities (G-Secs), and also invest in instruments issued by the private sector. Insurance sector is a International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 205","large investor, led by LIC. Mutual Funds are significant investors in instruments issued by private sector and banks and to a limited extent in G-Secs. Corporate treasuries play a dual role as both Issuer and investors. When in need of resources, corporate issue instruments: long term (bonds \/ debentures) or short term (commercial papers). Foreign Institutional Investors (FIIs) or Foreign Portfolio Investors (FPIs) have a limited role in our market than would be perceived, due to limits on investment put by regulators as well as their perception about India. Role of the debt market The role of the debt market is channelizing the resources from the savers to the borrowers mentioned above. The savers are ultimately individuals or households with surplus to be saved \/ invested. However, the drops have to be added to make the ocean. The amount of money raised by borrowers like the Central Government, State Governments and corporates in public and private sector is big. Hence the market participants play the role of intermediation of retail deposits on one hand and dissemination of the bulk quantum on the other hand. Intermediation Banks: banks offer deposits \/ savings accounts \/ current accounts as products. Depositors, mostly individuals and to a limited extent MSMEs or corporates, place their surplus money. Banks are the leading investors in G-Secs. This has got to do with the SLR requirement (currently 18% of Net Demand and Time Liabilities), but it is also about the superior credit quality of sovereign securities. Insurance companies: insurance companies, comprising the giant LIC in public sector and multiple private sector players, are the second largest investor in G-Secs. Insurance companies sell policies and the mobilization through traditional \/ endowment policies are invested mostly in the debt market. Mutual Funds: MFs are leading investors in corporate debt, CPs and CDs. They are relatively small in deployment in G-Secs. MF run multiple schemes, popularly referred to as funds, which sell units and deploy the proceeds as per the mandate of the fund. Debt oriented funds invest in debt instruments. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 206","The three institutions discussed above play the role of retail mobilization and wholesale deployment. PFs and Trusts: these have investment mandates, either by a statute or internal constitution. Deployment is mostly in safe avenues like G-Secs or top rated corporate bonds. Corporate treasuries: this is an example of proprietary funds i.e. not depositors\u2019 or unit-holders\u2019 funds. Treasuries with surplus for deployment invest either through the Mutual Fund route or directly in the instruments like corporate bonds or CDs or CPs. Government Security (G-Sec) As per RBI\u2019s definition, a Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. It acknowledges the Government\u2019s debt obligation. Such securities are short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both, treasury bills and dated securities while the State Governments issue only dated securities, called the State Development Loans (SDLs). G-Secs carry practically no risk of default and hence are called risk- free gilt-edged instruments. In market parlance, G-Secs refer to instruments issued by the Union Government, and not the State Governments. G-Secs are securities which carry a fixed or floating coupon (interest rate) which is paid on the face value, on half-yearly basis. Generally, the tenor of dated securities ranges from 5 years to 40 years. The Public Debt Office (PDO) of the Reserve Bank of India acts as the registry \/ depository of G-Secs and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. Treasury Bills (T-bills) Treasury bills or T-bills are money market instruments (short term debt instruments) issued by the Government of India in three tenures: 91-day, 182-day and 364-day T-bills. Treasury bills are zero coupon securities that pay no interest. Instead, they are issued at a discount and redeemed at the face International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 207","value at maturity. For example, a 91-day Treasury bill of \u20b9100\/- (face value) may be issued at say \u20b9 98.20, that is, at a discount of \u20b91.80 and would be redeemed at the face value of \u20b9100\/-. The return to the investors is the difference between the maturity value or the face value and the issue price. Cash Management Bills (CMBs) In 2010, Government of India, in consultation with RBI introduced a new short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in the cash flow. The CMBs have the generic character of T-bills but are issued for maturities less than 91 days. Sub-types of G-Secs i) Fixed Rate Bonds: These are bonds on which the coupon rate is fixed for the entire life (i.e. till maturity) of the bond. Most Government bonds in India are issued as fixed rate bonds. For example, 8.24% GS 2018 was issued on April 22, 2008 for a tenure of 10 years maturing on April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly payment being half of the annual coupon of 8.24%) of the face value on October 22 and April 22 of each year. ii) Floating Rate Bonds (FRB): FRBs are securities which do not have a fixed coupon rate. Instead it has a variable coupon rate which is re-set at pre-announced intervals (say, every six months or one year). FRBs were first issued in September 1995 in India. For example, a FRB was issued on November 07, 2016 for a tenor of 8 years, thus maturing on November 07, 2024. The variable coupon rate for payment of interest on this FRB 2024 was decided to be the average rate rounded off up to two decimal places, of the implicit yields at the cut-off prices of the last three auctions of 182 day T- Bills, held before the date of notification. The coupon rate for payment of interest on subsequent semi-annual periods was announced to be the average rate (rounded off up to two decimal places) of the implicit yields at the cut-off prices of the last three auctions of 182 day T-Bills held up to the commencement of the respective semi-annual coupon periods. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 208","iii) Special Securities: Under the market borrowing program, the Government of India also issues, from time to time, special securities to entities like Oil Marketing Companies, Fertilizer Companies, the Food Corporation of India, etc. (popularly called oil bonds, fertiliser bonds and food bonds respectively) as compensation to these companies in lieu of cash subsidies. These securities are usually long dated securities and carry a marginally higher coupon over the yield of the dated securities of comparable maturity. These securities are not eligible as SLR securities but are eligible as collateral for market repo transactions. The beneficiary entities may divest these securities in the secondary market to banks, insurance companies \/ Primary Dealers, etc., for raising funds. Corporate Debt Market The demand of debt in the corporate is from companies when they require to make capital expenditure in their expansion plans. It can as well be to retire the expensive debt earlier contracted. The approach until a couple of decades has been almost entire through term loans from banks and financial institutions. The retails bond markets were not developed. They remain in its infancy after so many years. The debt market structure in India has been such that the Government is a giant borrower. In that government crowds out the corporate in borrowing actively and cost-effectively from markets. Company deposits Companies have been raising deposits from the public since ages. The rated offered ae much better (in excess of 2%) than their equivalent maturity bank deposits. It is because the risk in corporate deposit schemes is seen higher as they are not secured like bonds and debentures. Apart from the general public who have the appetite for this risk commensurate with higher returns, the segment who invest in such instruments are high net worth individuals and few organized investment schemes. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 209","Bonds and debentures Bonds have a tenure of maturity, an annual coupon rate which is paid on half-yearly intervals on the face value or par value of bonds. The coupons are higher than their equivalent residual maturity government securities. The bonds are usually listed on exchanges which increase the liquidity aspect. Corporate bond segment is not an evolved market in India. Mutual funds, pension schemes, insurance companies and provident funds are investors in corporate bonds. They are rated instruments and are secured debt. Debentures have the same features as corporate bonds. They are also rated and secured. Debentures have the call feature which is pre-specified and allows company to pay parts of the principal component gradually, starting a few years down the cycle until they are extinguished in the final year. The interest is payable on the outstanding amount of capital. Infrastructure Bonds These are bonds usually floated by the government and public sector undertakings to fund the long- term infrastructure projects. They offer a decent rate of interest along with tax benefits. They have longish maturity periods, between 10 and 15 years. They have a specified lock-in period before the buy-back, if any. They are listed and traded on exchanges after the lock-in period is over. The tax deduction benefits up to Rs 20,000 are on the invested amount. The interest income is added to the income and taxed as per slab rate applicable. Inflation indexed bond Inflation-indexed bonds as a concept in debt investments was released by the RBI is June 2013. These bonds have returns in the form of coupons which are indexed to inflation rate. The capital repayment is also indexed to inflation on maturity. There is a small coupon, say 1.5% which is assured on the capital invested. From the subsequent year this capital is increased in tune with the inflation rate registered and approved and a coupon of 1.5% is paid t9o the investors on this inflated capital. This goes on until the maturity of the inflation-index bonds and the inflated value of capital is repaid on maturity. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 210","Zero-Coupon Bonds & Deep Discount Bonds A Zero-Coupon Bond (ZCB) does not carry any interest, but it is sold by the issuing company at discount. The difference between discounted value and maturity or face value represents the interest to be earned by the investors on such bonds. Whereas Deep Discount Bonds (DDB's) are in the form of zero-interest bonds. These bonds are sold at a discounted value and on maturity, face value interest is paid to investors. In such bonds, there is no interest payout during the lock-in period. Tax-Free bonds Tax-free bonds are issued by a government enterprise to raise funds for a particular purpose. One example of these bonds is municipal bonds. They offer a fixed interest rate and hence are a low-risk investment avenue. As the name suggests, its most attractive feature is its absolute tax exemption as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of ten years or more. Tax-free bonds are an excellent choice for investors looking for fixed income like senior citizens. As government enterprises typically issue these bonds for a longer tenure, default risk is very less in these bonds, and you are assured of a fixed income for a more extended period, typically ten years or more. The government enterprises invest the money collected through the issuance of these bonds in infrastructure and housing projects. Tax-free bonds are the right choice for investors falling in the highest tax bracket. Masala Bonds and FCCBs (Foreign Currency Convertible Bonds) Masala Bonds are rupee-denominated debt instrument issued by an Indian entity in foreign markets to raise money, in Indian currency, instead of dollars or local denomination. These are the bonds issued outside India, by an Indian entity, in Indian currency. The major objectives of Masala Bonds are to fund infrastructure projects, ignite internal growth (via borrowings) and internationalize the Indian rupee. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 211","FCCBs are issued as a bond by an Indian company are expressed in foreign currency and the principal and interest to are payable in foreign currency. The maximum tenure of the bond is 5 years. FCCB is a quasi-debt investment, which can be converted into equity shares at the choice of investors either immediately after issue, or upon maturity or during a set period, at a predetermined strike rate or a conversion price. It acts like a bond by making regular interest and principal payments, but these bonds also give the bondholder an option to convert the bond into shares. The issuer may sometimes have a call option, generally with a call hurdle, i.e., subject to a minimum stock price at the time of call, which means that invariably at the exercise of a call, the investor would opt for conversion into equity. Convertible Bonds A convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond\u2019s lifetime. It is a hybrid security that possesses features of both debt and equity. Companies with a low credit rating and high growth potential often issue convertible bonds. For financing purposes, the bonds offer more flexibility than regular bonds. They may be more attractive to investors since convertible bonds provide growth potential through future capital appreciation of the stock price. Pass Through Certificates (PTCs) and Security Receipts A Pass-Through Certificate (PTC) is a certificate that is given to an investor against certain mortgage- backed securities that lie with the issuer. The certificate can be compared to securities (like bonds and debentures) that may be issued by banks and other companies to investors. Investors in such instruments are usually financial institutions like banks, mutual funds, and insurance companies. All the PTCs in the market are rated by agencies like CRISIL or Fitch ratings. Security Receipt means a receipt or other security issued by a securitization company or reconstruction company. The trusts shall issue Security Receipts only to QIBs and hold and administer the financial assets for the benefit of the QIBs. They cannot be strictly characterized as debt instruments since they combine the features of both equity and debt. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 212","Bank Fixed Deposit vs. Fixed Maturity Plans A bank fixed deposit is a contractual return product. The interest rate locked in initially is realized om maturity and it is not contingent on anything. There is no linkage to any market; the return is absolute in that sense. A Fixed Maturity Plan (FMP) is not a contractual return product in that sense. It is a close- ended mutual fund scheme with a defined maturity date. The usual SEBI rules on fund construct applies to FMPs. In addition, there is a rule that maturity of instruments in the FMP portfolio cannot exceed the maturity of the product. While returns in a bank deposit is known upfront, it is not so in an FMP. As a matter of SEBI rule, the AMC cannot communicate the expected return. The Scheme Information Document (SID) outlines the broad portfolio construct of the product, in terms of instrument category and credit rating. Going by the indicated portfolio construct, the evolved investor and adviser \/ distributor can guess of the expected return, as per levels prevailing in the market at that point of time. Company deposits vs debentures Company deposits are conceptually similar to bank deposits, the difference being the borrower is a company and not a bank. The difference is subjective or perception-based: a bank being a bank, has a special place in the financial ecosystem. If a mainstream bank were to near a default-like situation, the authorities and regulators are expected to step in. We have seen cases in the recent past: two private sector banks were at the brink of default, when the RBI stepped in to change the ownership. However, co-operative Banks are not in the same league; the regulators would go by the system-wide implications if a bank were to go bust. Companies are not as important; a company would not be rescued just for the sake of the depositors. Debentures, issued by the same company as the one accepting the deposit, is similar from the credit risk point of view. Here also there is a subjective or perception-based difference: deposits are little ahead. When it comes to crunch, i.e. if the company nears a default-like situation, they would prioritize depositors as it involves public at large. Debentures are also held by the public, but the market is International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 213","largely institutional and the investors in debentures are held mostly by institutional investors who come in through the private placement route. Evaluation of Ecosystem and Client Sensitivity in Managing Situations Understanding Clients - Risk Averse and Risk Seeking Risk profiling is foundational in many matters of money management. However, we must review a client\u2019s risk profile after having a clear understanding of what constitutes it. A combination of the client\u2019s willingness to take risk (Risk Appetite), ability to take risk (Risk Capacity) and the limits of enduring that risk (Risk Tolerance) is what in summation can be called the Risk profile of the client. Ironically, they may often mismatch, rather than being in alignment. A simple example is a client who exhibits a high ability to take on risk (a high asset base and negligible to low liabilities) but while in conversation, may express a low willingness to take risk (conservative by nature) and equally express high concerns when it comes to stomach negative returns (low tolerance). In other words, this was High risk capacity, Low risk appetite and Low risk tolerance! A client showing a low willingness to take on a certain risk, would be characterized as \u2018risk averse\u2019 with respect to that risk, while another client who is willing to endure short term swings, sometimes excessive, in the value of an investment while achieving her\/his financial goals would be termed a \u2018risk seeker\u2019. A risk seeker may be motivated by heightened need or desire for more than average returns to assume a commensurately larger risk with an investment approach, strategy or product. The kind of goals and priorities clients have sometimes make them risk averse or risk seeker in a limited way, e.g. with regard to specific goals which could be widely different such as retirement and vacation. Those wanting quick wins or looking for very short time frames to achieve voluminous financial goals end up projecting a high risk-seeking mentality! Risk Tolerance Questionnaires - Impact of Framing The risk tolerance questionnaires are constructed to evaluate the aspects of financial behaviour of individuals. The individuals have tendency to react based on risk present in an event and its uncertainty International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 214","element. People are usually risk-averse about gains, i.e. they prefer to accept a sure outcome over a gamble for a higher or equal expected value. Similarly, they are risk-seeking about losses, i.e. they prefer to reject a sure outcome in favour of a gamble for a lower or equal expected value. Hence, framing of questions on risk-tolerance have to be careful in order that the right risk tolerance of the individual is captured. The above is one of the inherent features of the Prospect theory, developed by Daniel Kahneman and Amos Tversky in 1979. The theory suggests that describing the objective risk inherent in a situation elicits the behaviour to that situation. Individuals dislike losses more than equivalent gains, but they are more willing to take risks to avoid a loss. The bias makes them overweigh options that are certain (as lesser assured gain) over those options that give them chance of winning more with a slight possibility of getting nothing. This bias however reverses when there is the prospect of a loss. Given a certain level of loss, individuals engage in risk-seeking behaviour to avoid a bigger loss. This elicits a different answer from individuals even when both the situations lead to the same outcome. What is described above is framing. The intermediaries, advisers and financial planners would be prone to the above framing bias while they conduct the analysis of financial risk of their clients. For every such situation described in the risk tolerance questions care should be taken to avoid framing to elicit an objective view on the client risk profile. Dilution in Risk Management due to Overconfidence (Adviser\/Client) Overconfidence, whether justified or otherwise, in one\u2019s abilities might lead to ignoring certain measure of risk management. There is a checklist in every job, be it a very mundane or a highly complex one. In the field of financial management, there are umpteen factors either contributing to or affecting the outcome. No one can predict some or all these factors to have a predetermined effect and thus a defined outcome. Most of these factors are within a band of possibilities, sometimes involving large ranges. However, abilities are sharpened to understand each factor and prepare a response which seeks to maximize the desired outcome while minimizing the downside. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 215","If they fail to learn, investors, as well as experts like fund managers and fund advisers may yield themselves to either overconfidence bias or over optimism bias or both, at some point(s) on their learning curve (and in some cases repeatedly). Overconfidence is an excessive belief in one\u2019s own capabilities or judgment of a situation. This overconfidence may be a result from a level of education, certification, credential attained in a field. The proficiency obtained with experience and their past record of successes would have made such professionals complacent. These may induce a professional to overestimate the potential of their recommendations, or equivalently underestimate the downside from risks associated with those recommendations. This may lead to suboptimal decisions being made, ignoring the risks present in an investment or financial recommendation. What about another group of professionals who possessed relatively less knowledge, experience and training? Their overconfidence may result from the fact that they blinded about their own limitations. These two scenarios are equally true in case of investors who make their own decisions as well as in case of managers and advisers. Over optimism is another bias that makes an individual to underestimate the likelihood of adverse events. Both overconfidence and over optimism lead to what we popularly describe as \u201cirrational exuberance\u201d much noticed in a majority of market players during the 2008 global financial crisis. They became so confident and optimistic of the continuance of a certain trend in market prices that they completely ignored the underlying value of the assets involved. Goal setting and emotions Retail Therapy - Emotional Spending to Escape Stress Emotional spending or \u2018retail therapy\u2019 is not purposive but is likely done under some stress, just to feel better. It is similar to eating a lot or more sugary substances when under stress. Left unchecked this emotional spending constrains budgets, besides getting laden with items that have no real need and a guilt later. In order to control something, we first need to measure it. So, we need to first figure out what those spending triggers are that push us to make unplanned purchases. By keeping careful track International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 216","of our spending and the periods of those spending, we can identify how the same are linked to emotions or stress. Experts suggest one of the ways to tackle this unplanned and emotional spending by giving oneself a 48-hour period to decide whether one really needs a certain item identified for purchase. It may lead to more objectivity in making those crucial decisions. Making the process of unplanned purchases difficult is another method. Do not carry credit cards if you identify yourself prone to such bouts of binge shopping. Carry only the cash needed for planned purchases, non- discretionary as well as discretionary. Online purchases are more in vogue now. The ideal way to check emotional spending under stress is to have a well laid out budget on non- discretionary and discretionary spends, only after setting aside money toward planned investments. Spend on non-discretionary or regular items first to avoid constraining this list later. Even if mood swings have their way, usually a much smaller budget allocated to such discretionary or irregular expenses will limit the damage. Remember that discretionary spending is a want driven spending whereas your non-discretionary spending is a need driven spending. Understanding and Addressing Home Country Bias in Investing We are usually guided by several biases without knowing them. They come ingrained due to our own past experiences, or the experiences shared by our parents, elders, friends and relatives. These biases determine our choices and fears, and substantially yet unconsciously influence how we conduct our financial transactions and more particularly investment transactions. We end up responding to our own make-believe risks when exposed to such processes. More than just being optimistic about one\u2019s domestic markets or an allegiance toward home country, it can also be worded differently as one\u2019s pessimism or a state of indifference toward global investing. Such bias creeps in across many decisions of investments \u2013 be it real estate, stocks, bonds and mutual funds to name a few. Resident Indians have been permitted to invest overseas under the Liberalised Remittance Scheme (LRS) prescribed by RBI and updated by them time to time. However, two decades into the implementation of the LRS, bulk of the remittances have started picking up in the last decade. From International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 217","that point of view, we can say that home country bias has stayed longer than we have understood it ourselves. For example, the opportunity of investing in performing internet and technology companies of the US, more specifically the oft-quoted FAANG stocks or Facebook, Amazon, Apple, Netflix and Alphabet (Google), caught the imagination of India\u2019s high net worth investors. The cumulative growth in the market capitalization of these select companies outweighs the remaining companies by over three times during the period 2012-2020. Optimizing Diversification and Portfolio Turnover Optimizing Diversification Diversification is a basic tenet to reduce the unsystematic risk. Mutual fund schemes have this feature ingrained as the moneys of retail investors are gathered to invest in multiple securities of one or more asset classes so that the performance is not skewed in any one direction, and the return is duly adjusted for risks. Whether in the same asset class or by combining asset categories, it is the concentration risk that gets reduced by diversification. However, there are many other risks that get covered in the process like credit risk, interest rate risk, market risk, liquidity risk, etc. By containing various investment risks, fund managers optimize returns working within those constraints. Direct investors usually are constrained, if not by the knowledge they possess about such risks, then due to having limited investment resources to address all these risks together. This is the reason they are advised to take market exposure through mutual funds. High net worth individuals, however, are in search of high returns which they believe can be obtained from concentrated portfolios. Although diversification is good, it impacts long-term performance by moving their portfolio return more towards the overall market performance. They prefer to go with portfolio management schemes (PMS) or Alternate Investment Funds (AIFs) where they can have frequent interaction with fund managers and get their portfolios customized to generate returns for the additional risks assumed. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 218","Portfolio Turnover As we have seen in the \u2018retail therapy\u2019 above, stress can even lead to an investor or trader indulging in too many and too frequent transactions, just to feel better or have a sense of control. Financial Planners do not advise to have high turnover in investments. It drains the money due to loads and transaction charges. Trading may lead one to be high on some occasions and equally low on identical number of other occasions. Our financial transactions should be guided by our short and long-term goals and the tax efficiency in achieving such goals. Too many frequent transactions, apart from associated charges and tax inefficiency, may lead us astray in our goal vision. Tendency of Chasing Past Performance A part of the disclaimer run by Indian mutual funds, as mandated by SEBI, reads, \u201c\u2026\u2026\u2026the past performance of the mutual funds is not necessarily indicative of future performance of the schemes. \u2026\u2026\u201d. It is common world over that the regulators prescribe that fund houses, managers and intermediaries sensitize investors about past performance of funds. The SEC (US) would thus prescribe, \u201c\u2026.past performance is no guarantee of future results\u2026\u2026\u201d or some fund managers would state, \u201cpast returns are not a predictor of future performance\u201d. Decision-making by Clients Behavioral finance can be defined as the science of applying psychology to finance. While traditional finance indicates that markets are efficient and rational, behavioral finance disputes that notion. Behavioral finance suggests that human beings are not always rational and do not always act in a rational manner. We cannot overstate the impact of this on financial markets, and, more specifically, on individual investors. The basic model of economic behavior assumes that individuals (along with organizations and even territories and countries) act in their own self-interest. Additionally, they do so with absolute rationality, and with more or less total access to all necessary information. To various degrees, this model has infused most economic assumptions over the years. Experience, however, does not always International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 219","support the universal applicability of these concepts. There are theories that show that individuals do not make absolute rational decisions the two most widely used, is Bounded rationality and Prospect theory. Prospect Theory Daniel Kahneman and Amos Tversky\u2019s prospect theory is a behavioural model of individual\u2019s decisioning making when required to choose an option from a set of risky options. In prospect theory individuals will evaluate their options using a reference point as a starting point which is usually status quo. There are three key behaviours: 1. Individuals do not have one risk preference. Risk aversion and risk seeking is dependent on the context. Individuals are risk averse with gains and risk seekers with losses. For example, if an individual is faced with a choice of walking away with $100 right now or waiting a day for 50% chance of walking with $200 the individual will choose the $100 now as this is certain. If an individual has an option of losing $100 now or waiting a day and having a 50% chance of losing $200 tomorrow, they will choose the latter. Individuals would not want to risk the certain income and they would take a risk if it meant a chance of not losing money. 2. Gains and losses are defined relative to a reference point. When people have been presented two options with the same outcome, but different routes to the outcome, they will most likely choose the option with a perceived gain. For example, you have $1000; option A - you can lose $500 and gain $300, and option B - you can gain $200 and Loose $400. The outcome is the same you will end up with $800. However, most individuals will choose option B because there is a perceived gain. 3. Losses and gains are not treated equally, gaining money is not as important as losing money. For example, winning $200, then losing $80 feels like a net loss even though you are ahead by $120. But loosing $80 first and then winning $200 will feel like a gain. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 220","Benchmarking and Peer Group Analysis When selecting a benchmark, the index used needs to be reflective of the investment strategy that the manager uses. A benchmark needs to exhibit the following: free of conflicts, providing objective pricing and having a transparent methodology. Assets and Sector Allocation Asset allocation is the selection of asset classes and assigning weight to those asset classes for a portfolio. Sector allocation entails allocating weights to specific sectors such as mining and transport sectors. These asset class and sector weights are evaluated against a benchmark portfolio. What is being analysed is whether, or not the allocation of weighting contributes positively or negatively to the portfolio return. Positive allocation occurs when the portfolio is overweighted in a sector or asset class that outperforms the benchmark and underweighted underperforming the benchmark. Negative allocation occurs when the allocations are over weighted in an asset class or sector and underperforms and underweighted in an asset class or sector that outperforms. Selection, Market-timing versus Selectivity and Net Selectivity Selection Selection is the selecting of individual securities within different asset classes relative to a benchmark. The performance of the portfolio is not really affected by the securities selection as the assigned weights in asset and sector allocation will determine the impact on performance. Larger the weighting larger the impact. Market timing versus selectivity Portfolio managers must have the ability of selectivity and market timing. Selectivity is the ability to select securities that will be able to deliver the expected returns given a level of risk. Market timing is the ability to predict the movement of the market and make the corresponding changes (buying and selling of securities) to the portfolio in order to outperform the market. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 221","Net selectivity Net selectivity indicates the excess return generated that is attributed to portfolio manager\u2019s selectivity abilities. Net selectivity measures the excess return compared with a portfolio with the same total risk. Measure of selectivity is excess return gained from stock selection ability, i.e. (net selectivity) + (return required for diversification). Stock Analysis process Sector Classification and Sectoral Rotation An investor who is investing in equities needs to understand how companies (stocks) are classified for purposes of diversification. This is because stock prices move up or down depending on the impact trends or the economic cycle have on an entire sector or industry. Without this information an investor may potentially invest only in sectors that have a significant correlation to the economic cycle and thereby increasing risk of losses but also buying high and selling low. There are four different sectors in the economy (i) Primary(raw materials), e.g., mining, and agricultural (ii) Secondary (finished products from the primary market), e.g., manufacturing and construction (iii) Tertiary sector(companies that provide a service to the consumer) e.g., retail and financial services (iv) Quaternary sector( these are companies that provide intertextual and\/or knowledge service). e.g., education and consulting. Sector analysis entails looking at companies that thrive in the conditions of an economic upswing\/expansion. These companies are those that benefit from the expansion phase due to factors such as low interest rates that lead to increased consumer spending and borrowing. This generally would be companies in the tertiary sector. In a contraction phase, investors will look for companies that are stable and perform well regardless of the economic cycle. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 222","Financial Advisory and Financial Planning Financial advice and financial advisory are not specifically controlled terms by the regulators across financial sector in India. However, depending on the sector to which they address, e.g. insurance and retirement, the respective regulators IRDAI and PFRDA define channels within which such advice should lie, the adherence to ethical guidelines, and the risk factors with respect to a client situation. They also encourage separation of advisory from plain distribution of financial products, and foster a pathway where a client\u2019s suitability to hold a certain financial product is taken into account even in a simple sale transaction. The terms \u2018investment advice\u2019 and \u2018investment adviser\u2019 are however regulated by the securities market regulator SEBI. The investment advice is in relation to securities and investment products, and investment portfolios which contain such securities and investment products. The investment adviser would mean any person, who for consideration, is engaged in the business of providing investment advice to clients or group of persons. Any person cannot hold out himself\/herself as an investment adviser, by whatever name called, unless duly registered with SEBI to do so. Financial Planning is a wholesome discipline which covers all areas of a client\u2019s personal finance. FPSB maintains financial planning as a process of developing strategies to help people manage their financial affairs to meet life goals. A financial planner may choose to specialize in a certain domain of personal finance, or a specific component of financial planning, but he\/she is expected to be well-versed with other related areas of a client\u2019s financial situation to assess the impact of his\/her advice. SEBI, in their Investment Advisers regulations, have defined financial advice to include financial planning. SEBI has also defined financial planning under the regulations as analysis of clients\u2019 current financial situation, identification of their financial goals, and developing and recommending financial strategies to realize such goals. A financial planner may choose to be on the execution side only, but wherever he\/she chooses a fee-for-advice from clients, it necessitates registering as Investment Adviser with SEBI. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 223","Scope of Financial Planning Services and Process Financial planning is defined as a process of developing strategies to help people manage their financial affairs to meet life goals. The financial planning components are spread across the components of financial management, investment planning and asset management, risk management and insurance planning, retirement planning, tax optimization, estate planning and wealth transfer. The combined effort to synthesize advice across all these components and deliver a full-fledged financial plan comes under Integrated Financial Planning. A financial planner can specialize to offer his\/her services in one or more components of financial planning, however, FPSB requires that financial planning professionals should master each of the Financial Planner Competencies at an appropriate level. A financial planner and client can specify in their engagement any one, more or all of these components to be chosen, and whether the scope of engaging financial planner is limited to developing strategies and presenting recommendations only, or extends to implementation and review, or both. In developing strategies to manage financial affairs to meet their clients\u2019 life goals, financial planners help their clients to fairly understand their financial situation and proposed strategies, and help them to stay on track. Their recommendations are mostly based on review of all relevant aspects of a client\u2019s situation across breadth of financial planning activities, including inter- relationships among often conflicting objectives. When holding out as a financial planner, regardless of whether he or she is engaging in financial planning services or in product sales, a duty of care consistent with that of a fiduciary is owed to the client. Evaluating the financial position of clients: Assets, Liabilities and Net worth There is comprehensive process of data collection, both qualitative and quantitative, in order to determine the financial position of a client. A financial planning professional creates a repository of all financial assets, valuables and physical assets by securing the physical certificates of holdings, Demat accounts, records of land and property, jewelry and bullion, precious stones, art\/artifacts, collectibles, vehicles, etc. A rough valuation of assets, wherever needed, is also done. The liabilities of client are taken on record across long-term debts like mortgage loans, car loan, etc., and short-term loans like personal loans, credit card loans, etc. Details like contracted amount of loans, tenure, finance costs and International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 224","other terms, and their current outstanding loan amounts are recorded. The professional also ascertains any other financial obligations not on record such as loan guarantees given to friends\/relatives. The gross amount of assets as reduced by the liabilities standing against them gives the net worth of client. Depending on situation, the professional advises a client to make adequate provisions for doubtful assets as well as the illiquidity position of certain assets to arrive at actual net worth. The financial planning professional assesses the annual income of the client from all sources, as well as current and foreseen expenses\/financial obligations in order to arrive at net annual disposable income. This may be required to assess the current financial position of client and how it is likely to change in the near future. This income level seen against assets, liabilities separately, as well as in combination as net worth, are the parameters necessary to arrive at various financial ratios to adjudge the financial situation of a client and the quality of financial health. Trade-off between Investing Money and Paying-off Loans Should you invest excess cash or use your excess cash to repay outstanding debt? Simply put, choosing between the options to grow your cash or using it to reduce the interest cost on a loan. This is a decision that all individuals are faced with when they have intermediate surplus cash out of certain event such as a matured investment or a bonus. Debt vs Investment Both debt and investment have interest rates. The interest on debt is a cost while interest on an investment is income. When looking at the rate of return from investments, the real rate of return after inflation and tax must be used as the net income will be reduced by taxes. Often the cost of debt is higher than the real rate of return an investment may earn. Should that be the only criterion, the decision would be a no brainer! However, like most of personal finance decisions you need to consider more than just numbers. Financial needs and goals must also be considered. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 225","Using the above example: What if the client\u2019s one goal was to save for a holiday? Does the client have an emergency fund to take care of the unexpected situation that may arise in the interim, if the decision is taken to paying off debt early? Strategies to get rid of debt faster - Avalanche, Snowball, Blizzard The only way to reduce debt quicker without it costing you more or selling assets to pay off debt, is to increase payments above the minimum amount. This would require excess income over and above expenses. If an individual needs to reduce debt and does not have the additional income, then assessing expenditure to find areas where expenses can be reduced to free up money will be required. The equated monthly instalments consist of a portion toward capital repayment and the other toward interest. As you progress through the term of the debt, the interest portion which at the beginning of the term is a significantly large portion of the instalment amount. This would decrease as the term progresses, and the ratio will eventually become in favour of the capital portion. Any amount paid above the equated instalment, will go toward decreasing the capital and thereby make paying the debt quicker. Avalanche In Avalanche method, the debt with the highest interest rate will be paid off first, regardless of what the individual debt amount owed is. Once the highest interest rate debt is paid off, the focus will be on next highest rate debt if the amount still remains after discharging toward first loan. If one wants to make every rupee count, the avalanche method works the best. Snowball In Snowball method, the focus is on repaying the smallest debt (the outstanding principal amount of loan), regardless of interest rate. When the smallest outstanding amount is repaid, the focus would shifted to the next smallest balance. Because the focus is on the amount and not the cost, compared to the avalanche method this method may not be as cost-effective. However, paying off the debt with the smallest balance first will mean one is able to free up cash faster and therefore be able to utilize the International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 226","cash available to top up the EMI of the next debt or use for any other purpose. The snowball method will give one a sense of progress in reducing total number of debts, and will keep the individual motivated to pay up other debts that have piled up. Blizzard The Blizzard method is a combination of the avalanche and snowball methods. Starting with the snowball method first, the focus is on the debt with the smallest balance. Once this is paid off the focus then shifts to the debt with the highest interest rate, the avalanche method. The blizzard method first tackles the phycological aspect of debt management by creating a positive environment and motivation to stick to the plan. Once this progress is seen and one debt is eliminated, the motivation sets in to focus on the cost-effectiveness. The blizzard method is the best of both worlds. To feel motivated and to clear your dues, keep alternating between the two strategies. Which method to choose? If you look at the three methods from the numbers point of view, you would choose the method that is most cost-effective. However, we know that personal finance is never just about numbers. Deciding on a particular option is after evaluating financial needs, goals, sustainability of surplus discretionary income and the client\u2019s personality. If a client is self-disciplined, the motivation factor may not be needed and the focus can be on cost effectiveness, the avalanche method. If a client has a discretionary income, or irregular surpluses, freeing up cash in order to have consistent surplus income may be bigger priority than saving on interest costs. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 227","International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 228","REGULATORY ENVIRONMENT & COMPLIANCES International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 229","International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 230","Introduction to the Regulatory Environment What is Financial Regulation? Traditional economic theory suggests that there are three main purposes for financial regulation: 1. To constrain the use of monopoly power and the prevention of serious distortions to competition and the maintenance of market integrity; 2. To protect the essential needs of ordinary people in cases where information is hard or costly to obtain, and mistakes could devastate welfare; and 3. Where there are sufficient externalities that the social, and overall, costs of market failure exceed both the private costs of failure and the extra costs of regulation.\u201d The International Monetary Fund website provides a paper addressing a framework for financial regulation that identifies a three-way classification of regulation: 1. Economic, 2. Safety and 3. Information. An economic regulation system should result in a financial services sector that is: open to entrants; to new ideas about products and services; and to a competitive process that permits the better ideas and the more efficient organizations to flourish and spread their benefits throughout the economy. The components of a vigorous and sensible prudential regulatory system include: -Minimum Capital Requirements -Restrictions on Activities -Honesty and Competency -Prompt Corrective Action -Market Value Accounting International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 231","-Lender of Last Resort -Deposit Insurance -Personnel -Corporate Governance and Securities Regulation Requirements for timely, periodic issuances of information by publicly traded companies are an important \\\"lubricant\\\" for securities markets. Though such issuances are an inherent part of a corporate governance system, they are also an essential form of information regulation. The issuance of financial information should be standardized (so that lenders and investors can more easily make comparisons among enterprises) and, for example, use an accounting system that stresses standardization and transparency Regulators Requirements for timely, periodic issuances of information by publicly traded companies are an important \\\"lubricant\\\" for securities markets. Though such issuances are an inherent part of a corporate governance system, they are also an essential form of information regulation. The issuance of financial information should be standardized (so that lenders and investors can more easily make comparisons among enterprises) and, for example, use an accounting system that stresses standardization and transparency. As we are primarily concerned with investment-related regulations, we can begin exploring regulators by looking at the International Organization of Securities Commissions\u2014IOSCO. IOSCO is the international body that brings together the world\u2019s securities regulators and is recognized as the global standard setter for the securities sector. IOSCO develops implements and promotes adherence to internationally recognized standards for securities regulation. IOSCO was established in 1983. Its membership regulates more than 95% of the world\u2019s securities markets in more than 115 jurisdictions. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 232","Three goals or purposes of IOSCO\u2019s regulatory approach\/resolution: 1. To cooperate in developing, implementing and promoting adherence to internationally recognized and consistent standards of regulation, oversight and enforcement to protect investors, maintain fair, efficient and transparent markets, and seek to address systemic risks; 2. To enhance investor protection and promote investor confidence in the integrity of securities markets, through strengthened information exchange and cooperation in enforcement against misconduct and in supervision of markets and market intermediaries; and 3. To exchange information at both global and regional levels on their respective experiences to assist the development of markets, strengthen market infrastructure and implement appropriate regulation. Financial Instruments Directive In 2008, the European Union (EU) put into force the Markets in Financial Instruments Directive Its purpose was to improve the EU financial markets\u2019 competitiveness by creating a single market for investment services and activities. It was also designed to ensure a high degree of harmonized protection for investors in financial instruments . MiFID was reformed to become MiFID II. The revised regulations were adopted in May 2014 and MiFID II went into effect in January 2018. The European Securities and Markets Authority (ESMA) was charged with the responsibility of suggesting detailed rules for MiFID II. ESMA has already produced a number of detailed rules and is continuing to do so. As a key part of this process, in 2015, ESMA released guidelines specifying criteria for the assessment of knowledge and competence of investment firms\u2019 personnel, effective as of 3 January 2017. The ESMA Guidelines directly affect investment advisors in the EU, and may indirectly provide guidance for investment advisors in other territories. The MiFID II rules and the ESMA Guidelines create a detailed regulation framework for the regulation of investment advice International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 233","ESMA Guidelines V.II Criteria for knowledge and competence for staff giving information about investment products, investment services or ancillary services V.III Criteria for knowledge and competence for staff giving investment advice V.IV Organizational requirements for assessment, maintenance and updating of knowledge and competence Section V. IV is targeted to financial firms, while sections V.II and V.III focus on those interacting with clients. Notice the differentiation between V.II and V.III. The first (V.II) provides guidance for staff providing information about investment products, investment services or ancillary services. The second (V.III) lists criteria for knowledge and competence for staff giving investment advice. There is, here and elsewhere, a recognized differentiation between those who provide information and those who take the information and use it to provide advice. Investment advisors must understand risk-related components of the investments they discuss with, and recommend to, clients. Investment advisors must ensure suitability of the product solutions and (as important) recognize when a given investment product may not be suitable. In both sections, the regulations require understanding of the broader financial markets and the economy. There is also the requirement to understand all fees and costs, with the assumption that these will be explained to the client. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 234","There is also an expectation that both categories of financial staff (those who provide information and those who provide advice) will understand investment performance criteria as well as limits related to forecasting. All of this is in keeping with the goal of transparency and competency. EIOPA\u2019s Main Goals In the European insurance sector, The European Insurance and Occupational Pensions Authority (EIOPA) oversees Europe\u2019s insurance industry. EIOPA\u2019s main goals are: -Better protecting consumers and rebuilding trust in the financial system. -Ensuring a high, effective and consistent level of regulation and supervision taking account of the varying interests of all Member States and the different nature of financial institutions. -Greater harmonization and coherent application of rules for financial institutions and markets across the European Union. -Strengthening oversight of cross-border groups. -Promote coordinated European Union supervisory response. Legislated \u201cClient Best Interest\u201d Requirement The Fiduciary Standard Although the legal concept of fiduciary varies from territory to territory, the concept can be readily understood. A fiduciary obligation describes a relationship with the client that involves a level of trust, confidence and reliance on the fiduciary to exercise his or her discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his or her expertise and discretion to act on the client's behalf. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 235","Fiduciary Requirements One professional organization identifies that being a fiduciary encompasses three basic requirements: trust, loyalty and disclosure. They illustrate their position by asking three questions: Trust: Someone who does not completely trust their financial advisor can never be fully confident that they are receiving the best possible advice from the best possible advisor. Without trust, can client confidence be achieved? Loyalty: A financial advisor who is loyal to their clients will not be swayed by outside forces to recommend investments with higher commissions or payouts. Without loyalty, can clients be sure their own interests are being looked after? Disclosure: Clients must know, and understand, how their financial advisor is being compensated for the advice they are providing and whether any conflicts exist that may cause a problem with that advisor\u2019s ability to provide truly independent advice. Without disclosure, can the financial advisor provide prudent advice? Rules to Support Financial Markets MiFID has established a set of rules to support financial markets. The rules state that investment advice should be : \uf0b7 Fair \uf0b7 Transparent \uf0b7 Efficient \uf0b7 Integrated Fiduciary Duty and the Duty of Suitability Not every professional organization or territory has a fiduciary requirement. In fact, some territories\u2019 legal systems do not include the concept of being a fiduciary. Those territories and organizations will often hold to a suitability standard. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 236","Suitability is to be determined following an assessment of client requirements. A careful look at the two concepts\u2014fiduciary and suitability\u2014appears to show little difference in application. However, it is widely recognized that a client-first\u2014or fiduciary\u2014requirement is the greater while suitability is the lesser. Suitability requires that a financial advisor determine that a particular type of investment is suitable for the client. Under the suitability standard, the financial advisor could equally recommend an investment option that pays more commission, or one that pays less. Suitability does not require choosing the lower-cost option. However, as a fiduciary, if a lower-cost option is available, and the investment provides the same benefits, the financial advisor should recommend the lower-cost alternative. This does not mean that the financial advisor cannot earn a living. It does mean, that in placing the client\u2019s interest before his or her own, the financial advisor will recommend the lower-cost option, all else being equal. Rules-based standards tend to focus more on specific suitability requirements, while those that are principles-based lean toward the higher \u201cclient first\u201d standard. If a financial advisor embraces the principles-based client-first standard, the advisor will in every reasonable way do their best to support the client\u2019s goals and objectives by doing what he believes to be in the client\u2019s interest. The financial advisor will put the needs of the client first, before their own. Economic Environment and Financial Advice Monetary policy is the domain of a territory\u2019s central bank, while fiscal policy is more directly tied to the federal government\u2019s budgetary process. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 237","A central bank will often use monetary policy either to stimulate or slow down economic growth. In simplest terms, at least in theory, monetary policy can encourage either spending or saving, depending on whether the central bank wants to speed up or slow down economic growth. The central bank has three main tools to accomplish its monetary policy objectives: 1. open market operations, 2. the discount (interest) rate and 3. reserve requirements. The central bank uses open market operations as a primary tool to impact the supply of bank reserves (the amount of funds banks must hold against deposits in bank accounts). When the central bank wants to increase the supply of money in the economy, it will buy government bonds, thereby infusing additional cash into the system. Conversely, when the central bank wants to remove money from the economic system, it will sell government bonds, taking in cash and reducing the available money supply. Discount rate is the standard term used to identify interest rates. It can be used either in the context of the rate charged to borrow money or the rate applied as earnings on savings or investments. When applied by a central bank, the discount rate is the interest rate the bank charges commercial banks to borrow money. When the central bank wants to tighten monetary policy, it will increase rates, while a rate decrease indicates the bank wants to ease policy. Actions by the central bank in this area have the additional indirect effect of impacting all other interest rates in the economy. Banks are required to maintain certain reserve levels to help assure soundness and the ability to function as anticipated by the public and required by the government. The central bank periodically adjusts the required amount banks must keep in reserve as a tool to increase or decrease money supply. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 238","When the central bank wants to decrease money supply it will increase its reserve requirement. This means banks must hold on to greater amounts of deposits to maintain required reserves. Conversely, when the central bank wants to put more money into circulation (i.e., increase money supply) it will reduce reserve requirements. This allows banks to lend more (increase credit), thereby facilitating consumer and business spending. Where monetary policy is largely set by the central bank, fiscal policy is determined and implemented directly by the government. It is the modification of government spending or taxation with the objective to help achieve a more positive economic environment. Fiscal policy impacts aggregate demand, which represents the total spending on goods and services produced and consumed in the economy at a given time and price level. The Business Cycle Business Cycle It is valuable to look at the economic environment on both a long-term and a short-term basis. The business cycle focuses on the short-term. It is a recurring pattern in the economy consisting first of growth, followed by weakness and downturn (recession), and finally by recovery and a resumption of growth. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 239","The business cycle reflects a territory\u2019s output and unemployment picture. Output is the term used for real gross domestic product (GDP). Unemployment is simply the percentage of the available labor force that does not have jobs. Economic Expansion There are four primary areas of spending otherwise known as gross domestic product (GDP): 1. Consumer spending and housing 2. Business investment 3. Government spending 4. Exports When the economy is expanding, each of the primary areas is most likely growing. Much of the reason for this is confidence. Bubble A boom may result in a bubble\u2014that is, consumer confidence skyrockets, with the result that they are more than willing to pay ever-higher prices for the goods they desire. Bubbles most often occur in the investment area. In several territories, the housing market attained bubble status as individuals, investors and corporations continued to pay higher and higher prices for houses and other buildings. The assumption was that the market would keep going up (it never does; markets always go through rising and falling periods). Downturn & Contraction The expansion period is often (usually) typified by increasing inflation. Suppliers know they can raise prices and still sell goods, so they do. Unemployment is low, and finding (and keeping) good employees gets a bit harder. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 240","As a result, employees demand higher salaries, and employers start increasing wages. They can do so because they know they can recapture the additional expense (i.e., cost of goods sold) by increasing the price of their goods and services. For a time, this process aids economic expansion, but eventually it contributes to a slowdown. The expansion period is often (usually) typified by increasing inflation. Suppliers know they can raise prices and still sell goods, so they do. Unemployment is low, and finding (and keeping) good employees gets a bit harder. As a result, employees demand higher salaries, and employers start increasing wages. They can do so because they know they can recapture the additional expense (i.e., cost of goods sold) by increasing the price of their goods and services. For a time, this process aids economic expansion, but eventually it contributes to a slowdown. Recession & Depression What is the difference between a recession and a depression? There is no absolute answer. A depression is usually defined as being a bad recession, but there is no explicit definition. One way to identify a recession is two consecutive quarters of a decline in GDP. Other methods exist, but all point to an ongoing decrease in economic strength. When the economy experiences an unusually long and strong downward turn, the term \u201cdepression\u201d may start to appear in conversation. As an example, some people define a depression as a contraction in economic activity of at least 10% or lasting at least three years (or more than two years).In other words, it is a really bad recession. Thankfully, most economies do not normally experience depressions. Recovery Many times, the business cycle moves from a period of recession into an increasingly strong recovery period. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 241","Recoveries are typified by increases in demand for goods and services. People become more optimistic and often begin making purchases they delayed during the recession. Prices are generally still low, but that condition doesn\u2019t remain for long. Economic Indicators Several key economic indicators: \uf0b7 Employment \uf0b7 Consumer spending (and consumer sentiment) \uf0b7 Gross domestic product (production and inventories) \uf0b7 Housing \uf0b7 Central bank \uf0b7 Foreign trade \uf0b7 Wages and prices Leading Indicators \uf0b7 Average hourly workweek in manufacturing \uf0b7 Average weekly initial claims for unemployment \uf0b7 Manufacturers\u2019 new orders for consumer goods and materials \uf0b7 Vendor performance, or delivery times index \uf0b7 Manufacturers\u2019 new orders for non-defense capital goods \uf0b7 Building permits for new private homes \uf0b7 Stock prices \uf0b7 Money supply in real (inflation-adjusted) terms (e.g., M2) \uf0b7 Interest rate spread between government bonds and central bank funds rate (e.g., 10-year Treasury bond and the federal funds rate) Lagging Indicators Page 242 \uf0b7 Average duration of unemployment \uf0b7 Inventories and sales ratio, manufacturing and trade \uf0b7 Change in labor cost-per-unit of output International College of Financial Planning \u2013 Challenge Pathway Prep Book","\uf0b7 Average rate charged by banks \uf0b7 Commercial and industrial loans outstanding \uf0b7 Changes in Consumer Price Index (CPI) for services \uf0b7 Ratio of consumer installment credit outstanding to personal income Social and Political Environments Government and Politics: Local Government Sentiment In this section we will explore government and politics in the context of its impact on: -Local (internal) economic environment -Legal and monetary issues -Political party gridlock and alliances -Regional economic environment -Looking outward from inside a territory -Participating as a regional member -Global economic environment -Trade -Financial markets and banking -Treaties and alliances Local Economic Environment National governments set the stage for each territory\u2019s economic environment. To be sure, there is argument over whether this is the government\u2019s role, but make no mistake, the government does have a great economic impact. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 243","Sometimes a government\u2019s impact comes from what it does directly to affect the economy. Other times, its impact comes from what it does not do. A government has two primary tools to impact its economy: the legislature and the central bank (and treasury). Regional Economic Environment No territory today exists in total isolation. What happens in the region around a given territory can have an impact on the economy. Territories in close proximity to one another are in a position either to positively or negatively affect each other\u2019s economies. This can be especially important if there are regional military conflicts. The reality is, governments change, nations plunge into civil or external war, trade agreements change. All these things should be considered when evaluating the economic environment. There can be implications for investments, standard of living, even personal and property safety. A financial advisor will recognize this and look carefully at a client\u2019s insurance and risk management portfolio. Global Economic Environment Economists generally group reasons why territories gain from international trade under three categories: 1. Absolute advantage 2. Comparative advantage 3. Economies of scale Social Welfare Policy Social welfare can be broadly defined as organized public or private social services for the assistance of disadvantaged groups. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 244","As a financial advisor, you should know the range of benefits that may be available, along with having a good directory of organizations that provide services. Further, when clients find themselves in a situation where they need to take advantage of social welfare services, it can be a good opportunity to step in and provide support. Taxation Policy Government-provided services often increase taxes. Tax rates can have a significant impact on an individual\u2019s available income and assets. Some territories have no income tax while others have taxes in excess of 50% (sometimes higher). As a result, a territory\u2019s tax policy provides incentive for the financial advisor to include tax planning as a service. Retirement Policy Retirement benefits are closely related to tax policy in many territories. Some territories don\u2019t provide any benefits while others offer full pensions, including health care benefits. It\u2019s likely that most territories fall somewhere between the two extremes. Government-provided pension systems vary widely across the globe. In a \u201cPensions at a Glance\u201d report from the Organization for Economic Cooperation and Development (OECD), in the aftermath of the global economic crisis, pension systems continue to be strained. This should come as no surprise, as economic recovery remains tepid in most OECD territories. Globally, this has meant that pension contributions have remained low, while there is increasing pressure for public pension reform. Territories generally have been increasing normal retirement ages and, in certain cases, decreasing government-supplied benefits. There have been continued incentives for people to work longer. Six Financial Planning Components Page 245 1. Financial Management 2. Investment Planning 3. Insurance and Risk Management International College of Financial Planning \u2013 Challenge Pathway Prep Book","4. Retirement Planning 5. Tax Planning 6. Estate Planning Compliance and Implications The International Organization of Securities Commissions (IOSCO) produced a paper covering compliance requirements for financial intermediaries, firms that serve as liaisons (or the \u201cmiddleman\u201d) between financial product manufacturers and product purchases. While the report focuses on corporate intermediaries, it has indirect implications for all intermediaries in the investment community. For our purposes, we will highlight compliance portions of the IOSCO report. According to the IOSCO report, compliance is intrinsic to the operations of market intermediaries because they must have systems or processes in place to ensure that they are complying with all applicable laws, codes of conduct and standards of good practice to protect investors and to reduce their risk of legal or regulatory sanctions, financial loss or reputational damage (italics added; IOSCO, p.4). Compliance with securities laws, regulations and rules (referred in the paper as securities regulatory requirements) is part of the essential foundation of fair and orderly markets as well as investor protection. It is equally important, however, that firms develop a business culture that values and promotes not only compliance with the \u201cletter of the law,\u201d but also high ethical and investor protection standards. Two key concepts that stand out are: 1. protecting the interests of clients and 2. preserving integrity of the markets. International College of Financial Planning \u2013 Challenge Pathway Prep Book Page 246"]