How to calculate effective yields on different type of tax saving bonds?

by Manshu on November 14, 2011

in Investments

I did a series of posts last year about how yield was being calculated on 80CCF tax saving debt instruments, and I see that there is a need to distinguish yield calculation on those type of instruments with the yields on instruments where interest itself is tax free like the PFC tax free bonds.

But first, we need to look at the nature of the tax benefits in the two instruments.

Tax benefit under the 80CCF bonds: What this does is reduce your taxable income by the amount of bonds you buy, and thereby reduce your tax liability.

So, if you have a taxable salary of Rs. 10.2 lakhs, and you buy Rs. 20,000 worth of these bonds then your new taxable salary will just be Rs. 10 lakhs and you won’t have to pay tax on the Rs. 20,000 that you invested in these instruments.

Since you are in the 30.9% tax bracket – you save  30.9% of Rs. 20,000 or Rs. 6,180 in tax.  Now, keep in mind that this is the only tax benefit you get and  you get this only once.

Once you start earning interest on 80CCF bonds – you are liable to pay tax on them like you are liable to pay tax on the interest you earn from a fixed deposit.

Due to this reason – people felt it was a bit misleading for bond issuers to show what the effective yield was for these bonds by taking the tax benefit into account, but ignoring the tax that you would have had to pay on interest income.

I wrote about this in the limitations on the way yields are calculated for tax saving bonds, and together with the other two posts on calculation of yields on tax saving bonds, and the L&T Finance yield example – these three posts cover all important aspects on the mechanics of yield calculation on such instruments.

Tax benefit under the tax free bonds: The other type of bonds are the tax free bonds whose interest is not taxable. These are like the RBI relief bonds that were issued a few years ago or the PFC bonds that are open for subscription now.

In these type of bonds – you don’t get any tax benefit by way of reduction of your taxable salary, but since the interest itself is tax free – that improves the effective yield, and the higher the bracket you are in – the better it is.

The way to calculate the effective yield on these type of instruments is to use the following formula.

Effective Yield  = {Interest Rate / (1 – Tax Rate)}

Now that you know how both the yields are calculated – it is fairly simple to compare the two. Just take the after tax yields of both the instruments and see which one is higher.

I will have a future post with a Google Spreadsheet to go along with it that shows some live examples, and that should make this mechanism even easier to understand.

{ 2 comments… read them below or add one }

Aparna November 15, 2011 at 11:16 am

Good article! To add on, recently in Economic Times there was an article about Railways getting Finance Ministry’s approval for raising tax-free bonds. Railways will raise close to Rs 10,000 crore for select capacity enhancement work. Thus we can conclude that the revenue loss from tax break on interest would be lesser that the market interest that the Ministry would have to pay to raise funds.

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Manshu November 16, 2011 at 12:09 am

Interesting observation, but the revenue loss is fairly significant is it not? say 15% of 10K crore up front on tax savings and then about 8% for the next five years or so – don’t you think they could raise the money at the same rate from the market?

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