From safety and tax efficiency point of view, one can look at tax-free bonds
facebooktwitter

Should You Invest in Tax-free Bonds?

It is estimated that Rs40,000 crore will be raised through tax-free bonds in 2015/16

Up and down is the new norm for financial markets. Therefore, investing in a mix of products has become all the more important, to ensure that your portfolio is not adversely affected if a certain asset class is down. For example, the past five year figures show that gold has given only five per cent returns over the period. Similarly, if you invest all money in real estate you might face difficulty in liquidating it in case you need the money on an urgent basis. The same goes with the stock markets. It is, therefore, important to diversify your portfolio with part of your investments going in safest options such as bank fixed deposits (FD), post office schemes and Public Provident Fund (PPF). The newest entrant to this market is tax-free bonds. It is estimated that Rs40,000 crore will be raised through tax-free bonds in 2015/16.

Housing and Urban Development Corporation (HUDCO), National Highways Authority of India (NHAI), Indian Renewable Energy Development Agency (IREDA), Power Finance Corporation Limited (PFC), Rural Electrifi cation Corporation Limited (REC), Indian Railways Finance Corporation (IRFC) and NTPC are institutions which have bonds that are scheduled in 2015/16. NTPC was the first public sector company to launch tax-free bonds this year.

TAX-FREE BONDS

Bank FD comes across as the safest option since it promises fi xed and assured returns, while protecting the principal amount. No wonder then, that it is the favourite investment option among the senior citizens. Compared to FDs, tax-free bonds offer interest on your principal amount, but come with longer maturities of 10, 15 and 20 years. Most importantly, as the name suggests, income is tax-free in such bonds.

INTEREST

Though interest rates on tax-free bonds are less than those offered by bank FDs, no tax on the interest earned makes them attractive, especially for those in higher tax brackets. Consider this: the effective yield on 7.36 per cent 10-year NTPC bonds for an individual in the 30.9 per cent tax bracket is 10.65 per cent. Similarly, for 15 years it is 10.90 per cent and for 20 years it is 11.03 per cent. Compared to that, the post-tax yield on an eight per cent FD for the same individual is just 5.52 per cent.

 

TAXABILITY

Although these bonds are tax-free, they are not eligible for deduction under section 80C of the Income Tax Act. Moreover, short-term capital gains are taxed at normal income tax rates, while long-term capital gains (from sale of bonds after more than one year) are taxed at 10 per cent based on indexation.

DEMAT ACCOUNT

Not all bonds are available in paper form. Some can be bought in demat form as well, like the NTPC bonds. But the government is slowly moving towards paperless transactions. Also, there is no lock-in period as these taxfree bonds are tradable on BSE and NSE. Once it gets listed on the exchange, you can sell them off if there is need for money.

REDEMPTION

You will be paid interest annually and on maturity the principal amount will be paid back. But selling bonds before maturity may not offer you the required amount as it depends on market conditions. The price of bonds is inversely proportional to changes in prevailing interest rates. This means when interest rates rise, prices of fi xed income securities fall and when interest rates drop, the prices increase.

CREDIT RATING

Tax-free bonds are rated by credit-rating agencies. For example: NTPC bonds are rated by ICRA, CRISIL, and CARE and have been assigned AAA ratings. ALLOTMENT DATE The date is determined by the board of the company and is notifi ed to the designated stock exchange. Interest is paid to bondholders from the deemed date of allotment.

WHAT SHOULD YOU DO?

The tax-free component makes these bonds attractive, especially for those in higher tax brackets (see Effective Yield on NTPC Tax-free Bonds). Suresh Sadagopan, founder, Ladder7 Financial Advisories, says: "From safety and tax efficiency point of view, one can look at tax-free bonds. Good thing about tax-free bonds is you can lock in return for 10, 15 and 20 years irrespective of the interest rate moving down. You can expect stable return in the long run."

Thus far in 2015, RBI has cut rates four times across January, March, June and September, as a move to support the economy. Following suit, most of the major banking players have reduced their interest rates on fixed deposits. SBI, ICICI Bank, HDFC Bank, Axis Bank, Oriental Bank of Commerce and Punjab National Bank have all reduced their rates by a maximum of 100 bps or one per cent, thus far. Currently, State Bank of India is offering a five-year FD at 7.25 per cent. As on date, an investment of  Rs5 lakh will fetch Rs7.16 lakh, on maturity. If the banks were to lower rate by 25 basis points or 0.25 per cent, the effective interest rate drops to seven per cent. In such a case, tax-free bonds are ideal to park your money from safety and tax efficiency purpose.

Moreover, with India's annual consumer price inflation (CPI) for the month of August eased to 3.66 per cent as compared to 3.78 per cent in July, it is expected that Reserve Bank of India will keep cutting rates in the near future. In the long run, experts say interest rates are expected to go down and it is the best time to go for taxfree bonds.