Investing in infra bonds? Don’t be fooled, check the real return first

“Would you like to invest in a product that gives you an assured return of nearly 14%?” asked the over-smart relationship manager at the bank.

I try to avoid these freshly minted, daily-shaving MBA types. But the 14% assured returns got my ears ringing.

“What is it that you have?” I asked.

“Ma’am, these are Section 80CCE infrastructure bonds,” he explained.

“And they offer 14% interest?”

“Oh no, they offer 8% per year. But if you take in the tax impact, the effective rate of return rises to 14%,” he said.

“Effective rate of return?”

“Yes, we call it the internal rate of return (IRR), which works out to 14%.”

Now, here was an MBA trying to do what he was trained to do. If you can’t convince them, confuse them.

“What’s IRR?” I asked

“It’s a way of calculating the return on investment. It is too complicated for you to understand.”

“Are you saying I am dumb?” I asked.

“No ma’am, only that the math is complicated.”

“So are you trying to pass off your ignorance as my dumbness,” I asked a tad aggressively.

“No, ma’am...”

“Let me tell you how you arrived at 14% assured returns. Section 80CCE of the Income Tax Act allows individuals investing in these bonds to make a deduction of up to `20,000 from their taxable income. Is that right?”

“Yes ma’am.”

“Let us take the case of a person in the top tax bracket of 30.9% who invests Rs20,000 in these bonds. The saving is Rs6,180 (30.9% of Rs20,000) as tax. Since every rupee saved is a rupee earned, the effective investment is only Rs13,820 (Rs20,000 - Rs6,180). On this I receive an interest of Rs1,600 (8% of Rs20,000) every year for ten years, which is the term of the bond. We now have a situation wherein you have invested Rs13,820 and on which you are earning Rs1,600 every year. So the normal concept of calculating return does not work. We use the concept of IRR to calculate return. And IRR in this case comes close to 13.9% or 14% as you were telling me sometime back. Is that right?”

“Right ma’am.”

“Wrong, sir. The IRR does not take a few things into account. First, it assumes that the interest being earned is tax-free. That is not the case. When you are in the 30.9% tax bracket while investing, you can’t suddenly be in the 0% tax bracket while paying tax. So, if you earn an interest of Rs1,600 every year and are in the 30.9% tax bracket, you are effectively earning only Rs1,105.60 (Rs1,600 - 30.9% of Rs1,600).”

“That’s right,” he murmured.

“Also, there is an inherent assumption built into the IRR. It assumes that the interest being earned every year is being reinvested at the same rate as the IRR,” I said.

“Sorry, I didn’t get that.”

“Tell me you didn’t sleep through the finance classes.”

“Actually, I did,” he said sheepishly.

“When you earn an interest of Rs1,600 every year, the IRR comes to 14%. But what this calculation assumes is that the interest is being reinvested at the rate of 14%. The Rs1,600 that is earned as interest at end of the first year is being reinvested at 14% for the remaining nine years. The Rs1,600 earned as interest at the end of the second year is being reinvested at 14% for the remaining 8 years, and so on.”

“Yeah, you see it’s complicated.”

“So are a lot of things in life, but that does not mean we don’t try and understand. I needn’t tell you now that it’s impossible to earn 14% assured return. So let’s assume a more realistic 8% interest being earned on the reinvestment. And there is a third thing that I forgot — the interest earned on interest is also taxable. So when we take all these things into account, the real effective rate of return comes to around 8.4% for those in the top tax bracket and 8.1% and 8% for those in the 20.6% and 10.3% tax bracket. Do you get it now?”

“Yes ma’am, that’s much lower than what I said.”

“Now, since you are in the business of mis-selling, let me tell you how you can even project an effective return of nearly 18%.”

“18%?” he asked incredulously.

“If you read the terms and conditions carefully, the bonds come with an option that allows a buyback after completion of five years and one day. Let us assume the bonds are bought back immediately after completion of this period. For those in the top tax bracket, it effectively means that Rs13,820 is being invested, and on which Rs1,600 is being earned as interest every year for five years.

The IRR on this comes to 17.9%, or nearly 18%, though if you build in all the things I explained above, the real effective return falls to 12.1%. For those in the lower tax brackets, it falls to 10.3% and 9%. Think about it,” I said and walked out.

As daddy would say, “Never trust a man who shaves daily.” He was so right.

The writer works in the financial services industry and can be reached at chandniburman@yahoo.com. Views are personal