Interest Rates seem to be in an across the board freefall mode! After SBI set the trend by slashing bulk deposit rates between 1.25 per cent and 1.90 per cent across various maturities last week, we’ve now been notified that the interest rate on the popular 54EC bonds issued by NHAI and REC have been slashed by 0.75 per cent (from 6 per cent to 5.25 per cent). 54EC bonds have a three-year lock in, and negate the capital gains tax that becomes due when you sell your property.
The interest from 54EC bonds are taxable as normal income, and the maximum amount you can invest in each Financial Year is restricted to Rs 50 lakhs. The effective post-tax interest rate of return earned works out to between 3.68 per cent and 4.73 per cent, depending upon the marginal tax rate applied (between 10 per cent and 30 per cent).
Before you’re instantly put off by the low post-tax return on these bonds, consider the actual ‘rate of return’ you’ll be earning from them after factoring in the taxes saved, and make an ‘apples to apples’ comparison with your other investment options thereafter.
Say, you’ve earned a long-term capital gain of Rs 100. All things kept unchanged, you’ll need to shell out Rs 20 as LTCG (Long Term Capital Gains Tax) in the year that the transaction was booked. That would leave you with Rs 80 to invest.
If, on the other hand, you decide to invest into 54EC bonds (even at the reduced rate of interest), you’ll save yourself a tax outgo of Rs 20, and receive a post-tax interest ranging from Rs 3.68 to Rs 4.73 each year for the next three years, depending upon your tax bracket.
The best way to draw up a cash flow table for this scenario would be as such: assume Rs 100 as the initial investment, Rs 20 (the amount of tax outgo saved) as a positive cash flow in the first year, and the annual interest pay-outs each year as positive cash flows for the next three years.
Surprisingly, this works out to an IRR (Internal Rate of Return) of 11.05 per cent for the worst-case scenario - that is, assuming the highest tax bracket. For the best-case scenario (a marginal tax rate of 10 per cent), it works out to 12.17 per cent. To put this number in perspective; had you instead chosen to pay Rs 20 as tax and invest Rs. 80 in equities, you’d need to generate year on year returns (compounded) of roughly 20 per cent to achieve a similar IRR from your investment!
Given that 54EC bonds are backed by the government and hence default risk-free, an IRR of 11.05 per cent isn’t too shabby. Unless you’re an aggressive risk taker who expects returns significantly higher than 20 per cent CAGR for the next three years from equities, it would be a wise move to steer your ship towards the safe port of call that is 54EC, reduced interest notwithstanding.
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