Tax Free Bonds – Interest payout reinvestment calculator

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

  • 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 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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36 thoughts on “Tax Free Bonds – Interest payout reinvestment calculator

  1. Balaji

    I think Taxfree bonds have its place in ones portfolio to the extent of debt portion of ones asset allocation. Depending on ones appetite for Equity and ones comfort level on required asset allocation ratio of Equity to Debt to reach any goals, irrespective of time frame, tax free bonds can take a good chunk of allocation in the debt portfolio of that person. I think it is similar to PPF that is also 15 year lockin but recommended in ones debt portfolio due to it inherent EEE tax advantages.

    Reply
    1. pattu

      If a tax-free bond has to make a difference in a folio, the lump sum investment must be significant. Maintaining desired asset allocation may become difficult if we lock a part of the folio this way. EEE has its own price. Someone who says I don't have the stomach for significant equity must also have the maturity to accept lower returns. Trouble is this maturity is required after 15-20 years and not now. If it works for you, great. I don't think we can make any kind of generalizations with these bonds just as we should not make generalizations about equity. Bottomline, we should invest as per risk profile of the goal and not of the individual.

      Reply
  2. Balaji

    I think Taxfree bonds have its place in ones portfolio to the extent of debt portion of ones asset allocation. Depending on ones appetite for Equity and ones comfort level on required asset allocation ratio of Equity to Debt to reach any goals, irrespective of time frame, tax free bonds can take a good chunk of allocation in the debt portfolio of that person. I think it is similar to PPF that is also 15 year lockin but recommended in ones debt portfolio due to it inherent EEE tax advantages.

    Reply
    1. pattu

      If a tax-free bond has to make a difference in a folio, the lump sum investment must be significant. Maintaining desired asset allocation may become difficult if we lock a part of the folio this way. EEE has its own price. Someone who says I don't have the stomach for significant equity must also have the maturity to accept lower returns. Trouble is this maturity is required after 15-20 years and not now. If it works for you, great. I don't think we can make any kind of generalizations with these bonds just as we should not make generalizations about equity. Bottomline, we should invest as per risk profile of the goal and not of the individual.

      Reply
  3. Balaji

    I understand your point that one must have maturity to accept lower returns from debt from longterm perspective . My point is different.. I am also a salaried employee who had started saving money for last 17-19 years.. Though I started with FDs and other debt products to begin with instead of equity, I have been a systematic investor into equity MF(always Growth option) for past 13-14 years. Other than readjusting poor-performing equity funds with better-performing equity funds and occasional readjustment of equity-debt portfolio, I haven't booked any profit as I know this is for my future goals that every middleclass indian has.

    My point is as follows:

    -Based on my risk appetite I have 60% equity and 40% Debt that I had religiously tried to maintain in good and bad times for more than a decade.
    - When I see my debt portfolio there has been a fixed portion of that portfolio that I kept rotating on tax-effecient FMPs and other Debt funds trying hard to avoid FDs as I am now in 30% tax bracket.
    - If I see my debt portfolio, it keeps churning 1-3 years naturally due to mostly FMP redemptions. Over last 1 decade my post tax-returns on debt portfolio is at best around 8-8.5%. I accept that as I know that is 40% of my portfolio. As it sounds from your argument, you are kind of 100% equity person. Good for you. But in I my case with 60% equity exposure and accepting lower returns in debt portfolio is good enough balance for me.
    - Though there is always some potential for rebalancing debt- equity portfolio I see that there is a significant amount of sum that has been built over years that I know will remain in debt which is what I classify as long-term debt portfolio.
    - For guys like me I see an opportunity in tax-free bonds whenever my long-term debt portfolio is ready for next churn as this amount has been quite stable for more than a decade.. Tax-free bonds gives me a nice balance as I can get annual interest out of it that I can use for my equity:debt portfolio rebalancing( not for consumption) and at the same time I stand a good chance to make 8.5 -9 % tax-free from these pseudo govt bonds.
    - I know and understand the risk when people talk about what happened to UTI etc.. But the same argument is there for my FMPs too.. What happens to firms that got the money out of the FMP pool and then default ? FMPs are also not risk free. For that matter FDs are also not risk free. I accept that risk. Also, I accept the reinvestment risk if the bonds are called early as I know I have to go back to instruments like FMPs etc for my debt portfolio.
    - Bottom line is based on my investment experience some of these bonds do find a place in your long-term debt portfolio. If someone is diluting their equity and putting everything into tax-free bonds then I understand your point.

    Reply
    1. pattu

      Appreciate your detailed comment. Thank you for taking the time and effort. I am not a 100% equity person. No one should be. I have pretty much the same asset allocation as you do. My debt is in NPS (mandatory for me), in PPF and a balanced fund.

      One size does not fit all. I am well aware of that. If you re-read my posts you will notice that I am only against blindly investing a lump sum that rots in a SB acc. into these bonds just because it is tax-free.

      You have your folio sorted out and recognise what you are doing. So you and I are on the same page. We are for investing with a plan. What we invest in, need not be the same.

      I am curious to know why you have not chosen a debt fund like a 'income' fund? Surely over the last decade or so you would have got a pretty good return without the hassles surrounding an FMP.

      Reply
  4. Balaji

    I understand your point that one must have maturity to accept lower returns from debt from longterm perspective . My point is different.. I am also a salaried employee who had started saving money for last 17-19 years.. Though I started with FDs and other debt products to begin with instead of equity, I have been a systematic investor into equity MF(always Growth option) for past 13-14 years. Other than readjusting poor-performing equity funds with better-performing equity funds and occasional readjustment of equity-debt portfolio, I haven't booked any profit as I know this is for my future goals that every middleclass indian has.

    My point is as follows:

    -Based on my risk appetite I have 60% equity and 40% Debt that I had religiously tried to maintain in good and bad times for more than a decade.
    - When I see my debt portfolio there has been a fixed portion of that portfolio that I kept rotating on tax-effecient FMPs and other Debt funds trying hard to avoid FDs as I am now in 30% tax bracket.
    - If I see my debt portfolio, it keeps churning 1-3 years naturally due to mostly FMP redemptions. Over last 1 decade my post tax-returns on debt portfolio is at best around 8-8.5%. I accept that as I know that is 40% of my portfolio. As it sounds from your argument, you are kind of 100% equity person. Good for you. But in I my case with 60% equity exposure and accepting lower returns in debt portfolio is good enough balance for me.
    - Though there is always some potential for rebalancing debt- equity portfolio I see that there is a significant amount of sum that has been built over years that I know will remain in debt which is what I classify as long-term debt portfolio.
    - For guys like me I see an opportunity in tax-free bonds whenever my long-term debt portfolio is ready for next churn as this amount has been quite stable for more than a decade.. Tax-free bonds gives me a nice balance as I can get annual interest out of it that I can use for my equity:debt portfolio rebalancing( not for consumption) and at the same time I stand a good chance to make 8.5 -9 % tax-free from these pseudo govt bonds.
    - I know and understand the risk when people talk about what happened to UTI etc.. But the same argument is there for my FMPs too.. What happens to firms that got the money out of the FMP pool and then default ? FMPs are also not risk free. For that matter FDs are also not risk free. I accept that risk. Also, I accept the reinvestment risk if the bonds are called early as I know I have to go back to instruments like FMPs etc for my debt portfolio.
    - Bottom line is based on my investment experience some of these bonds do find a place in your long-term debt portfolio. If someone is diluting their equity and putting everything into tax-free bonds then I understand your point.

    Reply
    1. pattu

      Appreciate your detailed comment. Thank you for taking the time and effort. I am not a 100% equity person. No one should be. I have pretty much the same asset allocation as you do. My debt is in NPS (mandatory for me), in PPF and a balanced fund.

      One size does not fit all. I am well aware of that. If you re-read my posts you will notice that I am only against blindly investing a lump sum that rots in a SB acc. into these bonds just because it is tax-free.

      You have your folio sorted out and recognise what you are doing. So you and I are on the same page. We are for investing with a plan. What we invest in, need not be the same.

      I am curious to know why you have not chosen a debt fund like a 'income' fund? Surely over the last decade or so you would have got a pretty good return without the hassles surrounding an FMP.

      Reply
  5. Balaji

    Thanks for your quick response. I agree in your case you have NPS which is mandatory and that seem to provide the equity-debt blance you are looking for. In my case it is a little different. But I agree as long as one is investing with a plan it pretty much should take of the goals that are reasonably set.

    With regard to income funds, I wouldn't say I haven't dabbled with it. In my investment experience I did have income funds in the past. What I started feeling is that most of the income funds to boost the returns take equity exposure upto 20-25%. The portfolio balance I was looking for in Equity:Debt became a litle more complex calculation. At the same time it doesn't stop me from putting 20% of the funds that I am willing to put in a income fund directly into a well diversified equity fund and put the rest in a FMP. I could generate similar or better returns at lower expense as FMPs are considerably lower expense ratio to income funds. I don't say I am right or wrong, but at the end of the day I wanted to keep debt and equity as separate buckets so I can manage it better. Of late I have also been trying to gain experience with investing into funds that focus on dynamic bonds, corporate bonds to keep a little of my debt portfolio also diversified..

    Reply
    1. pattu

      Thanks for your response. By an income fund, I was not referring to debt oriented funds like MIPs. I was referring to funds like Templeton India Income which is has 100% debt paper (dynamic/corporate/debentures/CDs etc.) that mature anywhere from 2-8 years or so. I find this simpler than FMPs where we need to reinvest from time to time and also account for tax each time.

      Reply
  6. Balaji

    Thanks for your quick response. I agree in your case you have NPS which is mandatory and that seem to provide the equity-debt blance you are looking for. In my case it is a little different. But I agree as long as one is investing with a plan it pretty much should take of the goals that are reasonably set.

    With regard to income funds, I wouldn't say I haven't dabbled with it. In my investment experience I did have income funds in the past. What I started feeling is that most of the income funds to boost the returns take equity exposure upto 20-25%. The portfolio balance I was looking for in Equity:Debt became a litle more complex calculation. At the same time it doesn't stop me from putting 20% of the funds that I am willing to put in a income fund directly into a well diversified equity fund and put the rest in a FMP. I could generate similar or better returns at lower expense as FMPs are considerably lower expense ratio to income funds. I don't say I am right or wrong, but at the end of the day I wanted to keep debt and equity as separate buckets so I can manage it better. Of late I have also been trying to gain experience with investing into funds that focus on dynamic bonds, corporate bonds to keep a little of my debt portfolio also diversified..

    Reply
    1. pattu

      Thanks for your response. By an income fund, I was not referring to debt oriented funds like MIPs. I was referring to funds like Templeton India Income which is has 100% debt paper (dynamic/corporate/debentures/CDs etc.) that mature anywhere from 2-8 years or so. I find this simpler than FMPs where we need to reinvest from time to time and also account for tax each time.

      Reply
  7. Balaji

    Thanks for that info. I thought all funds that have 'income' in its name are having some equity exposure.. You are right. my investment experience in income funds was limited to MIPs. Based on this note I think I will surely try such pure debt income funds.

    Reply
  8. Balaji

    Thanks for that info. I thought all funds that have 'income' in its name are having some equity exposure.. You are right. my investment experience in income funds was limited to MIPs. Based on this note I think I will surely try such pure debt income funds.

    Reply
  9. Dilip

    The discussion btwn you and balaji is very useful. It gave the confidence to continue sip for a long time.thank you both.balaji sir can you share your fund strategy regarding equity. Thank you

    Reply
  10. Dilip

    The discussion btwn you and balaji is very useful. It gave the confidence to continue sip for a long time.thank you both.balaji sir can you share your fund strategy regarding equity. Thank you

    Reply
  11. Balaji

    Thanks .. Really appreciate Pattu for tolerating my comments on his blog.. For me this blog and well as few other websites I follow is where I silently observe and tune my investment strategy based on the information I gather. I am not used to writing much but couldn't resist on this one as I had to validate my investment strategy.

    Dilip, there is nothing fancy about my fund strategy. It is a pretty dull and boring one. All that I follow is financial discipline not to touch what has been saved for future goals and not to be bogged by up and down swings of the market. .Other than that I also have similar funds like an average equity fund investor has who doesn't keep much investments in buying direct shares. Your usual HDFC top 200s, Quantum Longterm equity, Pru Dynamic, Franklin India Prima etc is what is my portfolio.. I guess people like Pattu do a great voluntary service to the average investor community who get educated by following what they write.

    Reply
    1. pattu

      Thank you for your response. As you see, you make a big difference if you stop observing silently and share your perspective with us! 🙂

      Reply
  12. Balaji

    Thanks .. Really appreciate Pattu for tolerating my comments on his blog.. For me this blog and well as few other websites I follow is where I silently observe and tune my investment strategy based on the information I gather. I am not used to writing much but couldn't resist on this one as I had to validate my investment strategy.

    Dilip, there is nothing fancy about my fund strategy. It is a pretty dull and boring one. All that I follow is financial discipline not to touch what has been saved for future goals and not to be bogged by up and down swings of the market. .Other than that I also have similar funds like an average equity fund investor has who doesn't keep much investments in buying direct shares. Your usual HDFC top 200s, Quantum Longterm equity, Pru Dynamic, Franklin India Prima etc is what is my portfolio.. I guess people like Pattu do a great voluntary service to the average investor community who get educated by following what they write.

    Reply
    1. pattu

      Thank you for your response. As you see, you make a big difference if you stop observing silently and share your perspective with us! 🙂

      Reply
  13. Vignesh Baskaran

    Awesome Pattu! But I agree that One should not blindly invest in Tax free bonds as it is giving a constant income every yr.; it should be based on risk apettite; tenure of the goal and returns expectation:).

    It s seriously Informative and that too you have taken my comment and provided your full analysis.

    and mentioned my name also:P.

    I want to know some more inputs on this

    the Reason for suggesting SIP of the Income generated out of the tax free bonds.

    1. Retirees generally risk averse. (My Parents atleast , they are 53, 47).

    so I thought the below model fits them

    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%).

    We are optimistic that Equity will deliver a Good inflation beating returns in Long run.

    Because we can come to this conclusion on seeing the Rolling returns calculator of sensex which i read earlier in your blog.

    But in a negative way say it did not deliver the expected return the first way would not have done much damage.

    We would be having a heavy damage in case of second option (Investing in Equity at the start itself).

    As the First option offers Downside protection (Capital protected) we Should settle ourself to the Low returns of 9.99% in Long run.

    Still I want to know your idea in case of senior citizens /People nearing retirement Startegy.

    In One of your discussion in the Blog you were mentioning to avoid Annuity, Tax free bonds and other long term products.

    In case you already have a Post you can suggest me and I will have a look and learn!

    Thanks for the detailed analysis!

    Regards
    Vignesh

    Reply
    1. pattu

      Hi Vignesh,

      I agree that investing the lump sum in X is not suitable for everyone. We will have to take into account our requirement. X need not be equity. It could be a debt fund or even an FD.

      Reg. how to plan a retirement corpus, I will do a post on that in a couple of days.

      It will be based on this:
      http://freefincal.com/income-ladder-calculator/

      Reply
  14. Vignesh Baskaran

    Awesome Pattu! But I agree that One should not blindly invest in Tax free bonds as it is giving a constant income every yr.; it should be based on risk apettite; tenure of the goal and returns expectation:).

    It s seriously Informative and that too you have taken my comment and provided your full analysis.

    and mentioned my name also:P.

    I want to know some more inputs on this

    the Reason for suggesting SIP of the Income generated out of the tax free bonds.

    1. Retirees generally risk averse. (My Parents atleast , they are 53, 47).

    so I thought the below model fits them

    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%).

    We are optimistic that Equity will deliver a Good inflation beating returns in Long run.

    Because we can come to this conclusion on seeing the Rolling returns calculator of sensex which i read earlier in your blog.

    But in a negative way say it did not deliver the expected return the first way would not have done much damage.

    We would be having a heavy damage in case of second option (Investing in Equity at the start itself).

    As the First option offers Downside protection (Capital protected) we Should settle ourself to the Low returns of 9.99% in Long run.

    Still I want to know your idea in case of senior citizens /People nearing retirement Startegy.

    In One of your discussion in the Blog you were mentioning to avoid Annuity, Tax free bonds and other long term products.

    In case you already have a Post you can suggest me and I will have a look and learn!

    Thanks for the detailed analysis!

    Regards
    Vignesh

    Reply
    1. pattu

      Hi Vignesh,

      I agree that investing the lump sum in X is not suitable for everyone. We will have to take into account our requirement. X need not be equity. It could be a debt fund or even an FD.

      Reg. how to plan a retirement corpus, I will do a post on that in a couple of days.

      It will be based on this:
      http://freefincal.com/income-ladder-calculator/

      Reply

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