Comparing fixed income instruments based on interest rates

Comparing bonds, bank FDs and NBFC deposits based on interest rates:

The interest rates published by most of the banks (SBI, HDFC, CBI etc) are for quarterly interest payments. So, if you go for a monthly interest payout option, the interest paid monthly will be at a discounted rate*. Although banks generally don't provide an option for half-yearly or yearly payout, it is important to know what the effective interest rate will be for these payouts (SBI publishes annual interest rate with quarterly compounding#. CBI also publishes annualized yield^)

This is especially helpful when you have to choose between bank FDs, NBFC deposits and bonds. NBFC deposits usually offer monthly, quarterly, half yearly and yearly payout options (eg: https://www.mahindrafinance.com/investments/fixed-deposit/Fixed-deposit-interes-rates) and the interest rate varies for these payouts - the longer the payout duration, the higher the interest rate is. Generally NBFCs FDs will offer a higher interest rate than bank FDs because banks are highly regulated and considered safe (they also carry insurance upto 5 lakh), while NBFCs are not subject to such stringent regulations and the chances of defaulting are relatively higher (depending on the NBFC rating). But when comparing the NBFC FD rate with that of a bank, please make sure you're comparing interest rates for the same interest payout period.

Similarly, bonds have a coupon rate, but it is important to know what the coupon frequency is. It is possible that one bond may offer a coupon rate that is higher than another bond, but the coupon frequency of the former is lesser than the latter. In this case, which bond should you choose? Here you should compare the effective coupon rate for the same payout period.  

Example: Bond A may give 7% coupon rate with annual payment, while bond B with the same credit rating gives 6.95% with quarterly payment. The question then is: what is the annual coupon rate for bond A, or what is the quarterly coupon rate for bond B? Following table shows this:

Coupon Rate	Bond A	Bond B
Quarterly	6.82%	6.95%
Annual	7%	7.13%

(this calculation is shown in the next section of this blog)

This shows that although superficially it appears that bond A should be chosen because of a higher published coupon rate compared to the published rate of bond B, when you compare the effective coupon rate for similar coupon frequency, bond B offers a higher rate. To calculate the effective annual coupon rate of Bond B, the implicit assumption is that the payout for each quarter will be reinvested into the principal at the end of each quarter - effectively, the interest gets compounded every quarter. Alternately, to calculate the effective quarterly interest rate of Bond A, the assumption is that compounding of interest happens every quarter (i.e. the 7% annual rate is the effectively annualized yield for an interest rate X, the interest for which is paid out quarterly . We need to find what this X is. And it comes to 6.82%).

Conclusion: When you look at the bank FD rate, coupon rate of bonds, or the interest rate offered by NBFC to decide which of them offers the best interest rate vis-a-vis the inherent credit risk, it is important to make sure you are comparing rates for the same payout frequency.

*This is what HDFC says:
https://www.hdfcbank.com/personal/resources/rates
1) Fixed Deposits for the tenor <= 6 months : Simple Interest is paid
2) Fixed Deposits for the tenor > 6 months with Quarterly Interest Payout option : On a Quarterly basis
3) Fixed Deposits for the tenor > 6 months with Monthly Interest Payout option : Interest is calculated for the quarter and paid monthly at a discounted rate over the standard deposit rate
4) Fixed Deposits for the tenor > 6 months with Interest Reinvestment option : Cumulative Interest for the Quarter is added to the Principal in subsequent quarter and interest is calculated on total amount

#This is what SBI says: "Annualised Yield Compounded Quarterly"
https://sbi.co.in/web/interest-rates/deposit-rates/retail-domestic-term-deposits

^This is what CBI says: "Annualised Yield"
https://www.centralbankofindia.co.in/en/interest-rates-on-deposit

Calculating annual rate for one payout period from published annual rate for a different payout period

To calculate the effective interest rate for a particular payout period based on the published interest rate for another payout period, you can use this tool provided by cleartax: 

https://cleartax.in/s/compound-interest-calculator

For instance, in the example above, Bond A offers 7% coupon rate for annual payout. To calculate the coupon rate for quarterly payout, in the tool above, enter 

• compounding frequency: 1
• principal amount: 100 (for better decimal precision, you may want to put 10000)
• annual rate: 7
• period unit: quarters
• period: 1

Now, multiply with 4 the 'interest earned' shown by this calculator. This is the effective annual rate with quarterly payout.

Similarly, bond B offers 6.95% coupon rate for quarterly payout. To calculate the coupon rate for annual payout, in the tool above, enter 

• compounding frequency: 4
• principal amount: 100 (for better decimal precision, you may want to put 10000)
• annual rate: 6.95
• period unit: quarters
• period: 4

The 'interest earned' shown by the calculator is the effective annual rate for bond B with annual payout.