Comparing Tax Free Bonds and SBI Fixed Deposit Returns

by Manshu on December 29, 2011

in Fixed Deposits

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!

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