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
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- 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.
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