Should you invest in Infrastructure Bonds?

We are past the half way mark for financial year 2004. A lot of investors are gearing up to invest Rs 100,000 (the maximum possible) in infrastructure bonds.

Some have already made their first round of investment in such 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 ICICI Bank (Safety Bond). For simplicity sake, we will consider only the 'cumulative' interest options:

• Invest Rs 5,000 and get Rs 6,025 after 3 years and 4 months.
• Invest Rs 5,000 and get Rs 6,750 after 5 years and 4 months.

Under Option 1, the effective return, without factoring in the tax benefit, comes to 5.75 per cent.

Under Option 2, the return is marginally higher at 5.78 per cent (due to the longer tenure).

Now let's factor in the tax benefit:

If you are a taxpayer, the returns are definitely not 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 timeframe in mind).

To really make a call on 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 remain 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 about 5 years (or about 3 years 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.

MF Performance

The last four years have been a distortion in both the equity and debt markets.

While the stock markets witnessed a huge correction in values post the bursting of the bubble in March 2000 (even today the markets are down about 25 per cent from peak levels), 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 (the selling ended only a few months ago), several equity funds have delivered compounded returns of over 20 per cent per annum over the last five years.

Not surprisingly, even though the markets have witnessed a substantial rally in the last six months, the leading mutual funds have outperformed the popular indices by a huge margin.

Even if you factor in a 10 per cent 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 even today, the equity markets are considered by many to be at a valuation level that seems relatively attractive given the developments that are taking place in the economy.

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.

Indeed, September 2003 did see the income funds posting marginally negative returns, which created a flutter among income fund investors.

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 7 per cent p.a., which is realistic over the long term.

This return of 7 per cent surely does compare well with what the Infrastructure Bond has to offer, given that income funds have the added advantage of liquidity and tax benefits (dividend from mutual funds are tax free in the hands of the investor).

Balanced funds, as an investment option, are 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 five years, and they too measure up very well on a post tax scale. They too should be considered as an alternative.

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.

This article forms a part of Money Simplified -- Asset Allocation for Tax Saving Instruments, a free-to-download online guide from Personalfn. To download the entire guide, click here.