The financial year end is approaching and investors are gearing up to invest Rs 100,000 (the maximum possible) in infrastructure bonds. What we will attempt to answer here is whether or not it makes financial sense to make this investment.

Let’s take the tax saving product offered by IDBI (Flexi Bond). For simplicity sake, we will consider only the ‘cumulative’ interest options:

1. Invest Rs 5,000 and get Rs 6,550 after 3 years and 6 months
2. Invest Rs 5,000 and get Rs 7,450 after 5 years

Under Option 1, the effective return, without factoring the tax benefit, comes to 8.02%.

Under Option 2, the return is higher at 8.3% (due to the longer tenure).

Now let’s factor in the tax benefit:

Effective Return* Tax Bracket 3.5 yr 5 yr 10% 8.91% 9.22% 15% 9.44% 9.76% 20% 10.03% 10.38% Compounded Annual Growth Rate (CAGR)

The returns are definitely very attractive (let’s ignore the liquidity benefit as investment in equity and debt mutual funds too should be made with a 3 – 5 year time frame in mind). Especially when looked at from the post tax angle. However, what we are looking at are absolute numbers. To really make a call whether one should invest in these bonds or not, one should have an idea of the returns that can be expected from an alternate investment avenue.

Before we proceed with discussing alternative investment avenues, two very important features of the Infrastructure Bond need to be highlighted. First, unlike listed securities, there is no opportunity of making a capital gain if the interest rate environment were to turn favourable (the downside is limited as one can always hold the bond till maturity when it will be redeemed at par). And two, valid only if you were investing for a long term i.e. for your retirement or children’s education, the money is returned in a relatively short period of 5 years (or 3 years six months as the case may be). The reinvestment opportunities after 5 years will probably offer a return that is much less than what is prevailing today.

It has been said, and rightly so, that past returns are not indicative of future performance. But in case of products where returns are market determined, the past serves as an important indicator of what may or may not unfold in future.

	Past 3 yrs	Past 5 yrs
Fund Category	CAGR (%)
Income Funds
Templeton Income Builder	15.0%	14.1%
Sundaram Bond Saver	14.5%	14.0%
Birla Income	14.4%	13.6%
Equity Funds
Zurich India Equity	1.3%	28.3%
Franklin India Bluechip	0.1%	28.1%
Franklin India Prima Plus	-4.3%	28.0%
Balanced Funds
Zurich India Prudence	3.4%	20.9%
JM Balanced	12.1%	16.4%
Tata Balanced	-4.5%	13.3%
BSE 30	-11.4%	0.1%
NSE 50	-8.7%	2.4%

The last three years have been a distortion in both the equity and debt markets. While the stock markets have witnessed a huge correction in values, the debt markets, led by the several cuts in interest rates, have staged a rally not seen in many years. Even after factoring in these developments, attractive investment opportunities surface.

Take equities for example. Despite the incessant selling on the bourses since March 2000, several equity funds have delivered compounded returns of just under 30% p.a. over the last five years. Even if you factor in a 10% capital gains tax, you will still be better off than an investment in infrastructure bond by a factor of over 2x. Of course we have the benefit of hindsight. But then today, the equity markets are at a valuation level again not seen in many years (some call it the most attractively valued market in decades). Indeed, even modest expectations of the market factor in a substantial rise over the next 5 years.

For those who are familiar with the stock markets and are willing to take that extra amount of risk, equity mutual funds (in these present times) present a very attractive investment opportunity. And they should rightly opt for them.

But then equities are relatively more risky when compared to debt instruments and they do not suit the risk appetite of many investors.

The performance of debt funds going forward is difficult to gauge from past performance mainly due to the fact that the dramatic decline in interest rates that occurred over the last several years may not sustain for long. In the absence of such a structural decline in rates, the interest earned on the debt instrument becomes the main component of return while the capital appreciation is limited. Fund managers have often been quoted as targeting an annual return of 10% p.a., which is realistic over the long term.

This return of 10% surely does not compare well with what the Infrastructure Bond has to offer.

Balanced funds, as an investment option, is available to those investors who wish to hedge their risk by giving the fund manager an option to tilt the balance between debt and equity investments in case the situation in either one were to start looking grim. Balanced funds have done very well over the last 5 years, and they too measure up very well on a post tax scale. They too should be considered as an alternative.

Visit the Asset Allocator to get our view on expected returns from various asset classes

In a hurry to save tax today investors deploy their money in all sorts of infrastructure bonds, which offer an assured return (and to that extent the risk is limited). Some go to the extent of investing the entire Rs 100,000 in the same instrument, not realising that they could be better off paying tax.

In investing, there is a trade off involved – should I take more risk in the hope of getting a higher return or should I settle for the low but assured return? The answer probably lies midway.

Recommended Reading:
An investment product with the tax advantages of an insurance policy!
How to select the right Mutual Fund?

If you are in Mumbai and need help in planning your finances, give us a try. We are experienced and qualified and are in a position to meet your requirements.

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