Going by the IDFC bond maths, returns on SBI FDs will be 19.14%

“If you torture numbers enough, they will confess to almost anything,” goes an old saying, not attributed to anyone in particular. 

That’s how it is in the case of the infrastructure bonds, currently being offered by Infrastructure Development Finance Company (IDFC). The company is claiming a tax-adjusted yield of up to 17.85% to investors on buyback, which is completely misleading. IDFC infrastructure bonds are essentially 10 year bonds which pay an interest of 8% per year, and can be bought back by the company after a lock in of five years. The interesting thing though is the “astonishingly” high tax adjusted return being projected on these bonds. 

Section 80CCF of the Income Tax Act allows individuals investing in these bonds to make a deduction of up to Rs20,000 from their taxable income. This deduction is over and above the Rs1 lakh deduction allowed under Section 80C of the Income Tax Act.

As the accompanying tables, sourced from the IDFC website (www.idfc.com), show, the highest return being projected is 17.85%. This, in case the bonds are bought back after a five-year lock-in.

Now, how can a bond, paying an interest of 8% per annum, have an effective return of 17.85%?

Well, that is possible with some atrocious assumptions and a little bit of fancy math to torture numbers to project high returns.

And here is how it runs.

Let us say you come under the top tax bracket of 30.9% and invest Rs20,000 in these bonds. On investing in these bonds, you save Rs6,180 (30.9% of `20,000). A rupee saved is a rupee earned. So, technically, you invest only Rs13,820 ( Rs20,000 - Rs6,180) and that entitles you to an interest of Rs1600 (8% of Rs20,000) every year.

Also, after the lock-in of five years, the company buys back the bonds and pays back the Rs20,000 you had originally invested.

This situation does not entail itself to returns being calculated in absolute terms, given that the various cash flows happen at different points of time.

So a concept called Internal Rate of Return (IRR) is used to calculate effective return. And the IRR in this situation comes to 17.85%.

So far so good, but did anyone ever tell you about this term called GIGO, or garbage in, garbage out?

While making the calculation, it is assumed that the interest earned on these bonds is not taxable, which is not the case.
So, what the company is effectively assuming is that at the time of investing, the individual comes under the top tax bracket of 30.9%, but when it comes to paying tax on the interest earned, he comes under the 0% tax bracket.

And that is a rather pessimistic view of life to have, as we shall see.

Moving from the top tax bracket of 30.9% to the no-tax bracket is largely possible under two situations. One is when a salaried individual who is earning a taxable income of more than Rs8 lakh and comes under the top tax bracket, retires and has a taxable income of less than or equal to Rs1.6 lakh (or Rs1.9 lakh in case of women) and thereby comes under the 0% tax bracket. So, when he invests in these bonds, he falls in the top tax bracket, but when the interest starts coming, he comes under the no-tax bracket.

The other situation is when a salaried individual is fired from his or her job and thus does not earn enough to come under the top tax bracket continuously for a period of 5 years, when he is earning interest on these bonds.

The other inherent problem with this calculation is the way IRR is structured.

There is an inherent assumption built into the IRR — that the interest earned every year is reinvested at the same rate as the IRR.

So when you earn an interest of Rs1,600 every year, the IRR comes to 17.85%. But what this calculation assumes is that the interest earned every year is being reinvested at the rate of 17.85%. The Rs1,600 that is earned as interest at end of the first year is being reinvested at 17.85% for the remaining 4 years, till the company buys back the bonds. The Rs1,600 earned as interest at the end of the second year is being reinvested at 17.85% for the remaining three years and so on.

Now, only if real life had an investment avenue that guaranteed 17.85% assured returns year on year.

The third issue that is neglected is the fact that the interest or the return earned on the reinvested amount is also taxable.

So the interest or the return earned from the Rs1,600 that is reinvested every year is also taxable.

Of course, when we adjust for all these deficiencies, the effective return falls to around 12%. It is assumed that the interest earned every year is taxable at 30.9%. Also, the after tax interest is reinvested every year at the rate of 8% every year and is in turn taxable at 30.9%.

This logic works for all the other calculations of effective return put out by the company for the various scenarios on these bonds. So, for the situation in which an effective return of 13.9% is being projected, the real return is only 8.4%.

The financial services industry has taken to these high effective returns and is promoting the issue big time.

But should IDFC, which is 17.89% owned by the President of India (effectively the government), also be doing this, and thereby misleading prospective investors?

For one, the Rural Electricity Corporation, which is also offering infrastructure bonds currently, has not indulged in any of these fancy calculations.

The bigger question though is whether financial institutions should be allowed to project effective returns in this way.

God forbid, if the State Bank of India (SBI) were to use the same method to calculate effective returns on its five-year, tax-saving fixed deposits, currently paying an interest of 9%, the effective return would come to a whopping 19.14%. Now, SBI does not do anything like that. So why should IDFC be allowed to do so?