Comparing Tax Free Bonds and SBI Fixed Deposit Returns

There has been a lively debate about how to compare the yield between tax free bonds like NHAI and something like a ten year SBI fixed deposit in the comment section of the NHAI tax free bond. This debate was started by a calculation from Amlan Basak, and then others have weighed in on his calculations.

Savio had made a similar comment a few days ago, and basically what they are saying is that since bank fixed deposits are compounded 4 times a year, whereas the bond interest is compounded only once a year – the returns from a SBI bank fixed deposit is going to be higher than a PFC or NHAI bond issue in the long run.

Let me reproduce Amlan Basak’s comment here because he is the one that has done the calculation.

Currently SBI is giving 9.25% for 10 years FD.
let’s assume you invest 1,00,000.
With quarterly compounding interest the maturity amount will be 2,49,544 (though it is surprising but it is the power of compounding).
Interest component = 1,49,544
Tax @30.9% = 46,209
So, effective maturity value = 1,00,000+1,49,544-46,209=2,03,335

for NHAI, simple interest of 8.2% will yield 82,000 in 10 years
So, final amount = 1,82,000
It is less by 21,335

Please let me know if I made any mistake in the calculation.

(Note: I am not considering how we are going to invest the 8200 per year that we will get as interest)

There are a few things that I want to highlight in this calculation.

First point and he has himself acknowledged that is the fact that he has not included the NHAI interest amount reinvestment in his calculation. So, on one hand you have the SBI money that is put to work by you at the high rate of interest but on the other hand you have the interest amount from NHAI or PFC that is not reinvested but is supposed to do nothing at all.

Scenario NHAI SBI Fixed Deposit
Money from NHAI is not reinvested & money from SBI is reinvested. Tax Rate is 30.9% Rs. 1,82,000 Rs. 203,335

If you had  assumed that the NHAI interest is also reinvested at the 8.2% that is the original bond’s coupon rate then you actually get Rs. 2,19,923 which is about Rs. 16,000 higher than the SBI fixed deposit amount. This is probably theoretically, a more correct way of comparing these two.

Scenario NHAI SBI Fixed Deposit
If NHAI interest is also reinvested along with SBI interest Rs. 2,19,923 Rs. 2,03,335
If money from NHAI is not reinvested & money from SBI is reinvested. Tax Rate is 30.9% Rs. 1,82,000 Rs. 203,335

Reinvestment makes a big difference and another way to highlight that is to look at what would happen if you reinvested NHAI interest but simply took the SBI FD interest home with you every year.

Scenario NHAI SBI Fixed Deposit
If NHAI interest is reinvested but SBI FD interest is not reinvested Rs. 2,19,923 Rs. 1,66,170
If money in either is reinvested (Tax at 30.9%) Rs, 2,19,923 Rs. 2,03,335
If money from NHAI is not reinvested & money from SBI is reinvested. Tax Rate is 30.9% Rs. 1,82,000 Rs. 2,03,335

But coming back to the original calculation I can understand why Amlan Basak didn’t consider investing the Rs. 8,200 back from the bonds, and this is what Kiran tweeted out to me some time ago as well – that for most people they will not reinvest the money and it will just lie in their bank accounts. Hence for majority of investors the cumulative option on bonds is better than the annual interest one.

The thing to consider in this is that you don’t see anything from your SBI investment for 10 long years, but you are getting Rs. 8,200 paid out to you from NHAI every year. With the high inflation that we have today – you just can’t compare the absolute sums from the two investments. Rs. 2,03,335 is worth a lot less in ten years than it is today. So, to really evaluate these two cash streams you should see the present value of these two cash flows. That means you see what the maturity amount ten years from now is worth in today’s rupees and then compare that with the cash flows on the bond. In this case, the present value of cash flow from bonds is higher than the present value of the fixed deposit. I have assumed inflation to be at 7%.

Scenario NHAI SBI Fixed Deposit
Present value of money if money from NHAI is not reinvested and money from SBI is reinvested. Inflation is assumed 7% throughout Rs. 1,19,924 Rs. 1,03,365
If NHAI interest is reinvested but SBI FD interest is not reinvested Rs. 2,19,923 Rs. 1,66,170
If money in either is reinvested (Tax at 30.9%) Rs, 2,19,923 Rs. 2,03,335
If money from PFC is not reinvested & money from SBI is reinvested. Tax Rate is 30.9% Rs. 1,82,000 Rs. 2,03,335

I have done all these calculations on a Google Spreadsheet that you can access here. It is read only so you can copy it to your own spreadsheet and make changes.

Another aspect of these numbers is that you are supposed to pay tax on the interest income every year so that will reduce what you get at the end of year. This has been pointed out by Vaibhav.

The take away for me has been that these bonds don’t offer as sweet a deal as I earlier thought them to offer and thanks to Amlan Basak and Savio for that. However, if I had an option I would definitely opt for the bonds instead of the SBI fixed deposit.

Since this has been a complicated exercise I won’t be surprised if I made mistakes, so I’d request you to review the numbers and point out if I made any errors. And like always, comments are welcome!

53 thoughts on “Comparing Tax Free Bonds and SBI Fixed Deposit Returns”

  1. Hi All,
    What I have done it, I have opened an HUF account ( Me as Karta and my wife ), it is very easy process, takes 45 days time and 94 INR 🙂 (For applying for PAN card) . And then you can make FD’s in HUF account and enjoy returns upto 2 Lacs tax free, approximately you can do an FD of 20 Lac. And in case you would like to increase the FD then can use 1 Lac taxable benefit under section 80 C – 5 years Bank FD. So now you can do 30 Lacs FD :). Currently I have started doing FD of axis bank for 5 years @ 9.25 (TAX Free – Compounded Qtry).

  2. Hi,
    May I understand why have you ignored the tax calculation on income post maturity (tax on returns) on the infrastructure bonds ?

    Infrastructure bonds are bound to taxation (interest part alone).

  3. I wished to know, if for suppose i invest 10 crores in a tax free indian bond like the one discussed here, do i need to pay any tax on the coupons i’ll be receiving every year? Is it worthwhile to invest in tax free or taxable fixed deposits.. As around 40% might just be deducted as tds capital gains etc….?

  4. You all have converted simple math to some sort of a complex exercise.

    Comparison has to be on the apple to apple basis.

    NHAI yeild 8.2% pa tax free simple interest Total payout 8200 on 1 lakh investement.

    SBIN 9.25% compounded quarter interest taxable total interest 9575
    tax at highest slab 30% ( I am not taking cess etc) 2872
    Net yeild at the end of the year 6703

    Which is far more less than the yeild given by NHAI.

    As to Capital gains when interest is paid out at the end of every year their will be no rise in the price of the bond, and it will be redeemed at par (the selling rate only). What ever is the price fluctuation that is only for the trading purposes.

  5. There are many fallacies in the calculations. 1) the tax free bonds do not have cumulative option. Interest is paid out every year. 2) there is no point in calculating tax on maturity (FD or bond) as we can’t predict the tax rates after 10 years. 3) Comparing options where FD interest is reinvested and bonds interest lies unutilized in the bank is not equitable comparison. 4) Even in cumulative SBI FD option, the tax is deducted every year and not at the end of the 10 year term.

    I think the simple way to compare tax free bonds and FD is to calculate yearly post tax return.

    1. Your points are valid Shirish though the difference between post tax yields is not enough of an indicator for people who really don’t need this money for 10 years and want to take into account the reinvestment and quarterly compounding benefit that comes with a fixed deposit.

      This post has all possible options that I could think of and I’m sure no one will agree with all of them but then you have to see which situation is correct for you and then choose that option to compare.

  6. If I invest 12 Lacs @ 8.32% in REC Tax Free Bonds, I will earn 1 Lac interest every year for next 15 years. If I invest this 1 Lac in PPF account for 15 years @ 8.5% (tax free), at the end of 15 years I will have 12 Lacs + 32.62 Lacs = Approx. 45 Lacs.

    Thus the REC Tax Free Bond can be my instrument for retirement planning or for marriage or education of children.

    I am not looking for any capital gain possibility here.

  7. The tax rate considered in all the above examples is 30% throuout 10 years. but tax rate may change so its not known how much tax will be deducted from the interest payments on the FD’s in every year. whereas tax free bonds will be tax free throuout the tenure.

  8. if we invest in Bonds and decide to trade. the loss or profit can be adjusted against our other capital gains or loss. so we can safe tax in that case.

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