Assured return schemes tend to account for a significant share of an investor's portfolio. As the name suggests, these schemes offer assured returns i.e. investors know upfront how much return they are going to earn from their investments. Therefore, there is less uncertainty i.e. lower risk associated with investing in such schemes. Notwithstanding the benefits offered by these schemes, not all assured return schemes make worthy investments.

Recently, the National Bank of Agriculture and Rural Development launched its new issue of Bhavishya Nirman Bonds. These bonds are essentially zero-coupon bonds. At Personalfn, we have received several queries from investors enquiring about whether these bonds are worth investing in. This article aims at answering these queries.

Before venturing into what these bonds offer investors, let us first understand what zero coupon bonds are all about.

Zero-coupon bonds

A coupon is an interest guarantee attached to a debt instrument; the coupon rate is the interest rate, which the holder of that debt instrument will receive. As the name suggests, zero-coupon bonds have no coupon rate i.e. there is no interest to be paid out. Instead these bonds are issued at a discount to their face value (Simply put, in a fixed income instrument, the face value represents the par value/nominal value; it is the amount payable to the holder of the instrument on maturity). The difference between the discounted issue price and face value is effectively, the interest that investor earns. For example, if the face value of a zero coupon bond is Rs 1,000 and its issue price is Rs 900, then the difference between the two i.e. Rs 100 is the return for investor (i.e. 10 per cent rate of return).

What BNB offers?

BNB is a zero-coupon bond with a lock-in period of 10 years. There is no call or put option i.e. investors cannot prematurely liquidate their investments in BNB through NABARD. However, to provide liquidity to investors, the bonds will be listed and traded on the Bombay Stock Exchange. Hence, investors will have the option to sell their holdings at market prices before maturity.

The current issue price of each bond is Rs 8,250 and the face value is Rs 20,000. Investors should note that the face value of the bond is actually the maturity value and not the buying price, as is the case with other investment avenues. For investors, this means that they will be issued the bond at Rs 8,250 and after 10 years they will receive Rs 20,000 for each bond they own. The difference of Rs 11,750 is effectively the return on their investments.

These bonds can be held in both physical as well as in dematerialised (demat) form. However, investors who wish to trade in these bonds once they are listed at the exchange, should compulsorily have them in demat form. Remember that on the stock exchange, depending on the prevailing interest rate, these bonds could trade at a premium or discount.

Tax implications

In terms of tax implication, the maturity proceeds from these bonds attract no tax deduction at source. Instead, the said income i.e. difference between face value and issue price, will be treated as capital gains and capital gains tax will be payable by the investor.

How much return do they offer?

As per NABARD, the current issue of BNB offers a post-tax yield of 12.82 per cent. But before investors get excited about this they need to check if the return of 12.82 per cent works out as projected; sadly it doesn't.

The advertised return is only the simple annualised return, which is not the conventional way to calculate returns i.e. it is nothing more than a clever marketing strategy to attract investors. The conventional parameter is compounded annualised growth rate (CAGR), which for the BNB is not very impressive. Moreover, the CAGR of 9.26 per cent, projected by NABARD, does not give the exact picture to investors. Let us understand this with the help of an example.

NABARD's projected CAGR

Here, the CAGR has been calculated before accounting for capital gains tax, which means the 9.26 per cent CAGR is the pre-tax return. In our view, it is important to calculate post-tax return for a more accurate picture. Below we have calculated the exact post-tax CAGR return if the BNB is held till maturity period (i.e. for 10 years).

As can be seen in the table, after accounting for capital gains tax, the returns that investors will receive after 10 years will be Rs 18,669 and not Rs 20,000. Consequently the rate of return will be 8.51 per cent CAGR and not 9.26 per cent CAGR as represented by NABARD.

What should investors do?

The most prominent feature of BNB is that they offer assured returns and are suitable for investors with a low risk appetite. Given the bond has a lock-in period of 10 years; investors will be locking in the yields for an unduly long period of time.

So, if you have no need for liquidity and have a very low risk appetite, then you may want to consider investing in this bond. But, do not put in all your money. Alternative avenues like Fixed Maturity Plans, though not as safe, but not high risk either, could offer you better tax-adjusted returns from time to time (for instance in March 2008, if liquidity does dry out like has been happening for a couple of years now, you could lock in your money at very attractive yields).

However, if you have appetite for volatile returns then consider Monthly Income Plans (MIP) from mutual funds. These plans could, over a period of time, generate double-digit returns. The downside -- since neither the return nor the capital is assured, you stand a chance to lose money. In our view, a well-managed MIP could however deliver attractive risk-adjusted returns.

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