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Read the fine print behind the 18% return claim

Read the fine print behind the 18% return claim
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First Published: Mon, Feb 14 2011. 09 05 PM IST

Updated: Mon, Feb 14 2011. 09 05 PM IST
Sellers of tax-saving infrastructure bonds would have you believe that you stand to earn up to 18% if you invest in these instruments rather than the coupon of about 8% that these instruments carry. Vikram Limaye, executive director, Infrastructure Development Finance Co. Ltd (IDFC), says this is the best reason why you should buy infra bonds. IDFC’s second tranche of infrastructure bonds closed for subscription on 4 February and garnered Rs 765 crore, the highest by any issue so far. While it’s a little spreadsheet trick that pumps up your return manifold—about which we will tell you a little later—we suggest that you still invest in tax-saving infrastructure bonds. And they’re just getting heated up, after a tepid response to the earlier tranches. The latest issues to hit the market are India Infrastructure Finance Co. Ltd (IIFCL) bonds and L&T Infra tax saving bonds. While IIFCL Infra Bond closes on 4 March, L&T Infra Bond closes on 7 March. Though we advised to invest in the past issues, we suggest you take a look at either of these two issues if you haven’t already.
Infrastructure bonds
Classified as long-term infrastructure bonds, these are 10-year debt instruments. They came into being after Budget 2010 allowed a separate tax deduction limit of up to Rs 20,000 under the freshly carved out section 80CCF, over and above the tax deduction limit of Rs 1 lakh under section 80C. Though you can invest over Rs 20,000 in infrastructure bonds, the tax deduction is available only up to Rs 20,000. These companies raise money from the public and then lend it to infrastructure projects. On account of longer gestation periods of such infrastructure projects (time taken to complete the project and start making money), these bonds are long term, which as per issues so far means at least 10 years. Following the budget announcement, the Reserve Bank of India (RBI) allowed Industrial Finance Corp. of India Ltd, Life Insurance Corp. of India, Infrastructure Development Finance Co. Ltd and any other infrastructure finance company as classified by RBI to issue such bonds.
Also see | How the returns stack up (PDF)
Issue specifics
Both issues have multiple options; each of them offers a buy-back. Let’s try and break them into digestible parts.
L&T Infra has two options— annual and cumulative—and both mature after 10 years. You can buy back your bonds after five or seven years. The annual series offers an interest rate of 8.20% per annum, while the cumulative option offers an interest rate of 8.30% per annum.
IIFCL Infra Bonds are of a slightly longer tenor. On offer are the 10-year and 15-year options. The interest rate for them is slightly lower than L&T Infra. While the coupon rate of the 10-year option is 8.15%, the 15-year option offers a coupon rate of 8.30%. While the 10-year option offers a buy-back after five years, the 15-year option offers a buyback after seven years.
Your money in these infrastructure bonds, much like any other tax-saving infrastructure bonds, will be locked in for five years. After that, you can either sell it on the stock exchanges where they are listed or surrender them through the buyback route. L&T Infra is listed on the National Stock exchange and IIFCL Infra Bond is listed on the Bombay Stock Exchange.
Pedigree of companies
When you invest in a debt instrument, it is essentially a loan that you give to the company who promises to pay you interest and the principal amount back on time. To begin with, look at the credit rating of the instrument. While IIFCL Infra Bond is AAA- rated, L&T Infra Bond is rated AA+. To compensate for a slightly lower rating, L&T Infra Bond has offered a marginally higher coupon rate. “It doesn’t matter even if our interest rate is slightly lower. A five basis points difference will not make a material difference”, says S.K. Goel, chairman and managing director, IIFCL. That the company, he adds, is government-owned lends comfort to investors.
Most, however, believe that there is nothing to choose from considering that RBI has taken care to ensure the pedigree of companies that obtained permission to raise money from the public and lend it to the infrastructure sector.
The head of fixed income fund of a bank-sponsored asset management, who did not want to be named, says: “Both credit ratings indicate that the papers are of good quality and there’s nothing much to choose between them. The pedigree of both the companies is good. You can either go for the instrument that simply pays the highest rate or go for a company that, say, has government backing”.
Are post-tax yields real?
Yes and no. It is fine to take into account the tax break you get when you invest and to deduct the tax you pay on the interest when the bond matures. But the trick of assuming reinvestment of interest each year to calculate the return is unfair. Do not believe the 18% return ad copy—it is just an Excel sheet manipulation of return on the bonds that return money each year. For the cumulative bond option, the post-tax yields in the bonds are looking quite good. For instance, back of the envelope calculations show that if you belong to the highest tax bracket (30.9%), your post-tax yield in L&T Infra Bond (cumulative option) comes up to 10.30%. IIFCL Infra Bond will earn you 10.18% in the 10-year option (cumulative) and 9.21% in the 15-year option (cumulative). “What you earn eventually after taxes is what ought to matter. Hence, it is important to account for post-tax yields,” says Limaye. Not all are convinced. Goel believes that post-tax yields are a mirage and depend on a host of factors. IIFCL did not share issue post-tax yield calculations. For the purpose of this story we worked the numbers on the tax saving at the point of investment and at bond maturity, we deducted the tax on interest earned from return to arrive at a true post tax return number. The tax incidence will vary according to the tax slab and the higher the slab, the more the benefit. We find that the best bond is the L&T 8.3% Infra, at the five-year buy-back threshold for the person in the highest tax slab. (See the table for the complete comparison).
What should you do
Despite the ads being mis-leading, these bonds are still worth the investment on their own steam. If you haven’t yet invested in the previous tranches of infrastructure bonds, we suggest you make the most of these two issues. You can opt for the cumulative option. Since the interest paying option pays interest only once a year, it may not make much of a difference to you. “As the tax deduction benefits are only available up to Rs 20,000, most investors wouldn’t put more than that. An 8% interest on this would come to Rs 1,600; this may not make any difference. Many investors therefore prefer to go for the cumulative option and get back the money in one shot,” says V. Krishnan, country head-distribution, Integrated Enterprises India Ltd, one of the largest retail distributors.
Mint Money recommends both; if you want to pick up purely the one that pays the higher interest rate, go for L&T Infra. Stick to IIFCL if you get comfort from government pedigree and a higher credit rating.
Graphic by Yogesh Kumar/Mint
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First Published: Mon, Feb 14 2011. 09 05 PM IST