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?
- 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%).
- 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
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.