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Tax Free Bonds

There is a lot of interest from Resident Indians and Non Resident Indians alike for parking bulk of their funds into ‘Tax Free Bonds’.

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Various organizations, like HUDCO (Housing and Urban Development Corporation), PFC (Power Finance Corporation), REC (Rural Electrification Corporation), NHB (National Housing Bank) among many others have floated tax free bonds with amazing success and acceptance with investors. Often these tax free bonds have been oversubscribes within a couple of days of opening issuance.

 

Features of a Tax Free Bond

Typical features of a Tax Free Bond issued after Government approval by PSU’s or Government backed entities are as follows:

$1>  These bonds are normally for a 10 year lock in period.

$1>  The tax free coupon rate is in the range of 7% to 7.5%, compounded annually.

$1>  The interest rates are different for Retail investors and a tad lesser for Institutional investors.

$1>  Retail investors can apply for upto Rs 10,00,000 per application.

$1>  Bond holders are normally at par with secured creditors (hence the bonds can be considered to be backed by assets).

$1>  There is no ‘call’ or ‘put’ option, ie: the primary exit option is only on maturity. However, the Bonds will be listed in the Stock Exchanges and the investor will be able to pre-maturely redeem the investment through the secondary market in the Stock Exchange.

$1>  The enhanced rate of interest for the retail investor is lost in case of secondary market purchase.

$1>  The interest earned is tax free.

 

Comparison with other Options

However let us have a look at the arithmetic behind the ‘tax free’ bonds to what is the degree of benefit enjoyed by an investor.

The analysis and comparison is done by taking the following basic variables:

$1>  Resident status of investor

$1>  Income level and tax slab of investor

$1>  Gross and Net returns

$1>  Lock-in period and Liquidity

$1>  Re-investment opportunity and Security

 

For an investor, few of the basic options to park funds into similar category and class of investments are:

$1>  Bank Fixed Deposits

$1>  Mutual Fund Bond Funds

$1>  NSC / PPF

$1>  Corporate Deposits

 

Hence we need to see, what is the degree of benefit in investing into tax free bonds rather than the instruments mentioned above. Basic comparison of various features is as follows:

Investment Instrument

Tax Free Bonds

Fixed Deposits

Debt Funds

Corporate Deposits

PPF

Organization

Public Sector Units

Banks

Mutual Funds

Corporate Houses

Post Office/PSU Banks

Tenure

10 Years

1 month to 5 Years

1 Year to 5 Years

1 Year to 5 Years

15 Years

Liquidity

Secondary Market

Premature Withdrawal

Redemption with exit loads

Premature Withdrawal with Penalty

No Liquidity, but Loan possible

Security

Secured against assets

Guaranteed by banking insurance up to Rs 100000

Depending on the underlying asset

Secured against assets

Sovereign guarantee

Gross Returns

7.50%

9.00%

10% Un-guaranteed

10.00%

8.50%

Compounding

Annually

Quarterly

NIL

Half Yearly or Annually

Annually

Taxation

Tax Free

As per the Tax slab of Investor (0% to 30%)

Indexation Benefit on Capital Gains Tax, Dividend Tax Free in investor hands,

As per the Tax slab of Investor (0% to 30%)

Tax Free

Net Returns

         

0%  Tax  Bracket

7.50%

9.00%

10.00%

10.00%

8.50%

30% Tax Bracket

7.50%

6.30%

8.00%

7.00%

8.50%

 

Non Resident Indian (NRI)

Often NRI’s are restricted into investing in these Tax Free Bonds, however on an assumption of permission to invest, the as per us it does not make much financial logic for a ‘conservative’ NRI investor to invest in a tax free bond.

By a ‘conservative NRI investor’, I mean a typical NRI who is risk averse and will most likely choose security over returns. Hence for a conservative NRI investor is make better financial logic to park funds into NRE deposits, which as it is are:

$1>  Completely tax free and

$1>  Relatively secure with

$1>  Ample liquidity and provide

$1>  9% average rate of return.

The tax free bonds could have been considered as an option if the NRE deposit rates had not increased to the present levels and had stayed at the pre-increase levels of 4%-5% per annum.

Moreover if we consider a NRO deposit also, for the initial deposits (Rs 4000000), most of the interest can work out to be tax free, provided you don’t have any other Indian source of Income. There may be an applicable TDS on NRO deposits, however the TDS can be claimed back when you file your annual tax returns. Hence, even the NRO deposits can practically work out to be tax free for you to upto a certain amount of money.

One of the challenges is the tenure or duration of deposits offered by banks. Most banks offer a high interest rate for short tenures like 1 year or 2 years only. Quite a few banks don’t offer deposits of 10 years at all. Hence if you are looking at putting funds for a longer duration, it is better to compromise of the interest rates and place deposits for 5 years or 10 years, especially in a falling interest rate scenario.

Hence assuming a 7.5% return in a tax free bond, it makes more financial prudence to invest in a NRO or NRO deposit for the NRI as it will earn you an interest of 9%.

Now for an ‘aggressive NRI investor’, the Tax Free Bonds can be a blessing to park funds. As this option provides:

$1>  A long term (10 years) secured and assured interest rate,

$1>  A liquidity option through the Secondary Market,

$1>  An opportunity to gain against falling interest rates with higher return.

 

Secondary Market Bond Trading

Now, how can an investor gain more than the interest rate quoted by the bond? This is possible through the secondary market transactions. To consider an example, let us assume the following for a tax free bond:

Principal invested            : Rs 1000000

Interest Rate                 : 7.5% (Benchmark Rate – 2.5%)

                                    Tenure                         : 10 Years

Benchmark Rate             : 10%

We assume that the benchmark rate is the normal industry/economy macro interest rate which is used for the frame of reference and we assume NIL default risk.

 The investor will gain if the bench mark interest rate falls as the investor will have a bond bearing a higher interest vis-à-vis the rate prevalent in the market.

Say the benchmark rate has fallen by 1% after 1 year, your bond will continue to earn 7.5% as it is a fixed rate for the coming 10 years.

Hence any new investor in a bond, will actually be getting a 6.5% interest (Benchmark – 2.5%). Hence if you sell your bond to the new investor, you will receive 1% more for each remaining year, as your bond is running at 7.5% while the current rates are 6.5%, ie: 1% X 9 Years = 9% returns in 1 year. Add to this the interest that you have earned @ 7.5% for the first year. Hence your total earnings within 1 year can be 7.5% + 9% = 16.5% which at times is much more than what equity markets also provide.

A humongous 16.5% annual return by investing in a guaranteed and secure product.

It is advisable to invest in bonds in a falling interest rate scenario as if the benchmark interest rates go up then you may end up losing part of your principal is you choose a secondary market exit. However, if in a increasing interest rate scenario, you choose to hold on to the investment till maturity, then again there is no capital loss at all.

This is a win-win situation for a long-term investor.

 

Resident Indians

For Resident Indians, the arithmetic is similar. If you are in the NIL or lower tax slabs, it may not make financial sense to park your funds into a tax free bond. It is rather advisable to invest in bank deposits as the interest rates will be 9% which anyway is tax exempt for you as you don’t fall in the tax bracket.

However if you are in the 30% tax slab, this can be one of the better investment options for you as it is like having you cake and eating it to, where you get a fixed ling term assured return, with an exit option through the secondary market. The secondary market again can possible provide you windfall gains in a falling interest rate scenario (as explained previously).

All in all, the investment needs to be suited to your personal financial objectives and your financial plan.

The example and figures are indicative only and calculations are only for ideation and illustration. Actual calculations and market variable may be different. It is advisable to consultant a professional financial advisor to determine the suitability of this investment avenue to you and to your portfolio.

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