Nominal return versus real return is a fairly straightforward point. You earn returns when you invest in stocks and bonds. But then inflation takes away a part of the return in the form of higher prices. In economics, Inflation is regarded as the biggest thief of value. When you look at nominal returns adjusted for inflation then you get real returns. Let us understand this concept of real returns a little better with a formula to calculate inflation adjusted returns..
VariableCurrent ValueAfter 1 yearAfter 2 yearsInterest rate on Bond 10%10%Inflation 6%6%Investment valueRs.1000Rs.1100Rs.1210Nominal Returns Rs.100Rs.110Inflation adjusted PV
1-year & 2-years Rs. 1038Rs.1142Real Profit (Net of Inflation adjustment) Rs.38Rs.42Real Return (%) 3.80%3.82%
In the above example to calculate inflation adjusted returns, we can see that the real returns are substantially lower than the nominal returns due to the impact of inflation. You will see that the real returns in the second year are marginally higher than the first year. That is because, the impact of the net spread (10% interest - 6% inflation) is getting compounded each year.
The importance of real returns in investment evaluation..
The real returns adjust for loss of purchasing power and hence are more comparable across products and economies. Just saying that interest rate in India is 9% and in the US is 3% does not help. You have to look at these in real terms to be more comparable.
Once you understand the real return, you can simulate for impact of falling inflation on real returns. This is an important consideration that impacts the price of bonds. In fact, even in case of equities, this formula can used to gauge the impact of falling inflation on equity values.
Pre-Tax returns versus post tax returns..
Another way to look at returns is in the form of pre-tax returns versus post tax returns. The tax adjusted returns formula will differ according to 3 different situations viz. tax rebate on investments, tax on income flows and tax on capital gains. The formula to calculate tax adjusted returns will differ in each of these situations.
How do you compare the returns on an ELSS fund with a normal equity mutual fund? Structurally, both the funds are the same except that an ELSS fund has a 3-year lock in and therefore offers a tax rebate on the investment. How does that impact returns?
Equity FundParticularsELSS FundParticularsFund nameAlpha Equity FundFund NameAlpha Tax SaverNAV on 01-12-2014Rs.20NAV on 01-12-2014Rs.20NAV on 30-11-2017Rs.35NAV on 30-11-2017Rs.35Absolute Returns (%)75%Absolute Returns (%)75%CAGR Returns20.5%CAGR Returns20.5%Section 80C RebateNilSection 80C Rebate30%Effective InvestmentRs.20Effective InvestmentRs.14 (20-6)Effective Returns (%)75%Absolute Returns (%)150% (21/14)Effective CAGR (%)20.5%CAGR Returns35.8%
In the above case, look at how the effective returns increases substantially in case of Alpha Tax Saver due to the Section 80C benefit. Since the 30% rebate is available on the investment of Rs.20, the effective investment works out to just Rs.14. When you calculate the returns on a lower base, the effective returns doubles in case of the Alpha Tax Saver while the CAGR returns is also 75% higher in case of the tax saving option.
How does the impact on taxation change the effective comparison of different bonds with different rates of returns? Let us consider the example of a Corporate Bond and a NHAI tax-saving bond. The table shows the comparison..
Corporate BondParticularsTax-Free NHAI BondParticularsFace Value of BondRs.1000Face Value of BondRs.1000Annual Coupon (%)9%Annual Coupon (%)7%Tax statusFully TaxableTax StatusTax FreePre Tax InterestRs.90Pre Tax InterestRs.70Post Tax InterestRs.63 (90-30%)Post Tax InterestRs.70
In the above case, the corporate bond pays a 200 bps higher coupon compared to the tax-free bond. However, when you consider the tax impact of 30% on the corporate bond, the tax-free bond actually works out to be more attractive. Of course, there is a longer lock-in period for tax-free bonds but if that is not an issue then it is the tax-free bond that is more attractive in post-tax terms.
When it comes to capital gains, equity tends to get a much better treatment compared to debt. Of course, debt and equity are not strictly comparable as their risk profiles are different. However, the purpose here is purely to understand how tax treatment of capital gains impacts the returns on debt funds and on equity funds
Beta Equity FundParticularsBeta Debt FundParticularsNAV on 01-11-2014Rs.50NAV on 01-11-2014Rs.50NAV on 01-10-2015Rs.60NAV on 01-10-2015Rs.55Capital GainsRs.10Capital GainsRs.5Tax on CG15%Tax on CG30%Post Tax Cap Gains17%Post Tax Cap Gains7%
While the debt fund returns are already lower due to the lower risk profile, what needs to be noted is that the higher tax rate on debt funds imposes a higher cost. The period considered here is 11 months hence it is short term gains for both equity and debt funds. However, equity funds will become tax free after completing 12 months while debt funds will continue to pay 30% tax up to a holding period of 3 years and post 3 years it will still pay a tax of 10%. That is the extent of difference that tax treatment of capital gains makes to your effective returns.
Understanding the crux of real returns and post-tax returns helps investors to make more optimal investment decisions. Grasping tax-adjusted returns formula and nominal returns versus real returns lies at the core of the argument!