Limitations of the way yields are calculated for tax saving bonds

by Manshu on October 26, 2010

in Fixed Deposits

I’ve done a post about calculating yields on tax saving bonds, and on that post I focused on the mechanics of the yield calculation but that’s really the first step of the ladder.

You have to first understand how a yield is calculated in order to judge whether that’s the right way of calculating yields or not, and what are the limitations of it. I had this post originally scheduled for next week, but an email exchange with reader Amit Shah prompted me to post this earlier as that made more sense.

So, now that we are past the step of understanding how bond yields for tax saving infrastructure bonds are calculated let’s take a look at some more factors about these calculations.

1. They don’t take into account tax paid on interest: The way yields are calculated for the series that pays annual interest don’t take into account the taxes that you will pay on the interest received. This is just the way this calculation is done, and if you are comparing it with another instrument that you can invest in and won’t have to pay taxes on (like PPF) you should include taxes on interest in your calculation. However, if the instrument you are comparing these with also require you to pay tax then it may not make so much of a difference.

2. They don’t take into account capital gains on cumulative options: The cumulative option on these bonds mean that you will get a bond with a much bigger value at redemption compared with the face value. This will attract capital gains, but those are also not part of the calculation. Frankly, at this point I don’t know how those taxes come into play but these calculations are mute on them.

3. Yield on the shorter duration is calculated considering buyback has been exercised: The infrastructure bonds have come out with buyback options from the issuers where the issuer has the option to buy them back after say 5 or 7 years. This is a call option from the issuer which means that they may not exercise it, and you end up holding your bonds either till maturity or have to sell them on the exchange. The yields have been highest on the buyback options, so if they don’t exercise the buyback then the yield will reduce.

4. Yield to Maturity (YTM) assumes that you can re-invest the interest earnings at the same rate of interest: The YTM calculations are used to calculated yields on the series where the interest is paid out annually, and this assumes that the interest you earn will be invested by you in a security that earns the same rate of interest throughout the remaining period of the bond. This may not happen if you lose some part of the interest in taxes, or aren’t able to find another security that pays the same rate of interest as the original one.

5. They don’t take into account on bond listing: These bonds will list after an initial lock in period, and if the interest rates are higher at that time, then these bonds should list at a discount. In case that happens, and the issuer doesn’t exercise the buyback then you will either have to wait for the full term of the bond, or sell at a discount which will also reduce your yield.

Conclusion

It’s a good thing to be aware of yields because you obviously need them to compare with other products, but keeping these points in mind is a good reminder that the yield number is not cast in stone, and depends on a few other variables as well, and if some of these factors change then your yield will change as well.

{ 4 comments… read them below or add one }

priyalal adhikari January 17, 2011 at 8:59 pm

i want to know about the sec 80ccf of it act in details,please let me know

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Manshu January 18, 2011 at 2:40 am

Here is an earlier post about 80CCF questions that I did. I hope this answers all your questions, and if it doesn’t then please leave a comment with what’s unclear and I will answer it.

http://www.onemint.com/2010/12/09/section-80ccf-infrastructure-bonds-faq/

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bhupesh January 22, 2011 at 1:24 am

Do you know how tax will be payable on interest earned every year , every year or at maturity/redemption?

Reply

Manshu January 22, 2011 at 1:28 am

If you opt for getting interest paid every year then that’ll be taxed in that year itself Bhupesh. If you go for the cumulative option, then that will be taxed at the time you exercise the buyback or redemption, as that’s the time you will realize the income.

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