Sometime back I asked you through my article “While Investing, Should You See Annualised Returns or CAGR?” This I explained with some examples that how look like high returns annualised yields are mere single digits compounding growth only, which do not even beat inflation. With the current market volatility where equity seems to be a risky investment option many inventors choose fixed income instrument, like FDs as a better option whose returns are at least guaranteed, but fail to assess that they are investing just to get higher returns rather than better tax adjusted returns. Anyways tax comes later, first is how much is the return?
Many a time I see that some Banks or NBFCs offering deposit options with lucrative returns to the extent of 12%-13% even. Hold on! Don’t get excited. When you see such high returns, have you ever tried to figure out or re-read the brochure to understand what exactly they are saying? Whether it’s a mistake of your eyes or the financial institution has done it deliberately to lure you? I saw an NBFC offering 13.32% effective yield per annum for its 5 years deposit scheme. Sounds interesting! Yes, it’s true (they claim). But I don’t know whether it’s a printing mistake or they know this is enough to convert their sale. Before digging into more detail let me tell you what is an “Effective Yield” all about?
Effective Yield: The total yield on a particular bond/security, when interest payments are reinvested. The effective yield is always higher than the basic yield because interest from the investment is itself earning interest, an effect known as compounding. For such bonds/securities, effective yield is an annual rate of return associated with a periodic interest rate. In simple words, it’s a compounding return that arises when the principal invested is reinvested along with its interest earned over a period of time.
How does it work/example:
The formula for effective yield is:
i = Interest Rate
n = The number of payment periods in one year
Let’s assume you invest in a bank deposit scheme that offers you 8.50% interest rate per annum which is compounded quarterly.
Since the interest is compounded quarterly, number of payment periods in one year will be 4. Using the formula above, we can calculate that the effective yield is;
Hope you have understood what exactly an Effective Yield depicts. This is an accurate measure of the investor’s return than calculating a simple annual interest rate or annualised returns because it takes compounding effect into account. Now coming back to what I saw! Below is the image appended for the FD rate structure offered by a financial institution for their fixed deposit scheme. This looks superb as cumulative scheme gives you maximum of 13.32% per annum effective yield if you stay invested for 60 months.
This says on investment of Rs. 5,000 in the cumulative scheme, after 5 years (60 months) your annual effective yield will be 13,32% i.e. maturity value of Rs. 8,329 (principal + interest earned). But if you rub your eyes and look it again, you will see this is just annualised returns of 13.32% per annum not annual yield. Annualised returns are calculated based on adding first year returns to the principal amount for calculation of next years returns and so on and so forth.
In the above image: You have invested Rs. 5,000 for 5 years that becomes Rs. 8,329. Here you see the overall gain is Rs. 3,329 which is approx 67% (this 67% is the absolute return on the principal amount invested) of invested amount. Here annualised return will be (67%÷5) 13.32% per year not effective yield at all. Similarly, given 12.60% yield for 48 months deposit is actually 12.60% annualised yield for 4 years. So, what will be the actual yield then? What will be the net take home after paying tax on the interest earned? Let find out;
This shows how returns can be manipulated to present in an enticing manner so that one invests in it and eventually gets something which is even not crossing the growth of inflation year or year.
I am nowhere trying to de-promote such schemes rather trying to convey my message i.e. do your mathematics first before signing the investment application. In fact any bank or financial institution offering deposits with such returns (actual yields) will be more beneficial for lower or nil tax bracket investors.