Last Updated on December 29, 2015 at 4:32 pm
Many investors would like to park their lump sum in tax-free bonds, and invest the interest paid out each year in mutual funds, stocks or PPF. What if the lump sum was invested in a mutual fund/stocks instead of these bonds? Which option would fetch the investor more returns? Here is a calculator to evaluate your options.
In the previous post, I had mentioned a list of questions investors ought to ask themselves before investing in tax-free bonds.
The most important question is:
- How much return do I need for my financial goals?
Not
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
- How much return will I get if reinvest the interest payouts? or, how much return will I get if I invest the lump sum elsewhere.
So I strongly suggest that you first determine the return required for your financial goal using the calculator listed here: A Step-By-Step Guide to Long Term Goal-Based Investing
Once you know the return required, you have a reference for comparison.
You could now evaluate your options with respect to the tax-free bonds.
Here are some examples (all figures are approximate estimates):
(A) 1L invested in tax free bond @ 8.5% with payouts invested in any instrument (call it X) with post-tax CAGR of 8%. CAGR is the effective rate at which the money has grown using a compound interest model. I included the option to calculate CAGR after reading a comment by Vignesh Bhaskar in Ashal Jhauhari’s, facebook group, Asan Ideas for Wealth
After 15 years, total corpus is 3.3 L with a net post-tax CAGR of 8.3%
Had you invested the 1L in X you will get a corpus of 3.2L (CAGR 8%).
(B) 1L invested in tax free bond @ 8.5% with payouts invested in any instrument (call it X) with post-tax CAGR of 9%
After 15 years, total corpus is 3.5 L with a net post-tax CAGR of 8.7%
Had you invested the 1L in X you will get a corpus of 3.6L (CAGR 9%).
(C) 1L invested in tax free bond @ 8.5% with payouts invested in any instrument (call it X) with post-tax CAGR of 12%
After 15 years, total corpus is 4.2 L with a net post-tax CAGR of 9.99%
Had you invested the 1L in X you will get a corpus of 5.5L (CAGR 12%).
Bottomline:
- If the returns from X (the instrument chosen for investing payouts) is higher (or is expected to be higher) than the interest rate of the tax-free bond, then investing the lump sum in X will fetch a higher return than investing only the interest payout from a tax-free bond.
- If the returns from X is lower than that of the tax-free bond, then investing the interest payout from the tax-free bond in X will fetch a higher return than investing the lump sum in X.
- These simple conclusions can be arrived at without using any calculator. However, using a calculator allows you to estimate maturity values and net CAGR.
Which should we choose?
The answer depends on the duration of your goal and risk involved.
- If the duration of your goal is more than 10 years, would you not stand a better chance of getting returns well above inflation if you invested the lumpsum in equity?
- Typically most people will have to invest in equity in order to match their returns expectation, but do determine the return required for your financial goal before deciding.
- If the goal duration is equal to or less than 10 years, reinvesting tax-free bond payouts could work.
- However, you would need to be careful about the volatility of the reinvestment instrument X
- For less 10 years, should X be equity? Can you not do with a debt fund like a ‘income’ fund?
- Again, it depends on the returns you need for the goal.
- Let us keep in mind that we should be driven by reasonable expectations and not overcomplicate the reinvestment schedule just to save tax
Download the Tax Free Bonds Interest payout reinvestment calculator
Note: I have played around with different ways of calculating XIRR and IRR. If you have some interest in this, you can ‘un-hide’ a few columns on the right of the sheet and have a look.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)