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Tax free bonds are good for risk averse investors

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Consider returns, liquidity and safety before investing

TAX free bonds issued by government-promoted infrastructure development companies, will hit the markets again this year to raise Rs 60,000 crore, as announced in the Union budget. Last financial year, the National Highway Authority of India (NHAI), Power Finance Corporation (PFC), Rural Electrification Corporation (REC), Housing and Urban Development Corporation (Hudco) and Indian Railway Finance Corporation (IRFC), raised Rs 30,000 crore through this route.


Consider risk appetite: Risk-averse investors can consider tax-free bonds as a viable option to park their money. Going by the 10year benchmark yield at 8.16 per cent now, these bonds are likely to have 8 per cent to 8.50 per cent interest rate this year. Investors should consider all aspects, such as returns, liquidity and safety before investing in such new instruments.

In a tax-free bond, the tax advantage is not on the principal investment amount that in some instruments, such as public provident fund, can be deducted from the total income. The tax advantage in a tax-free bond is on the interest. The interest earned on the tax-free bonds is not added while calculating personal income tax. The interest is paid annually on a fixed date every year.


Matter of interest: A taxfree interest of 8 per cent and above is higher than bank fixed deposits (FDs), where 10-year rates of 9.75 per cent may fetch higher gross returns, but, post-tax returns for investors in the 30 per cent tax bracket will be lower because they will have to pay 30 per cent tax on the bank interest income. If an investor, in the 30 per cent tax bracket, invests, say, Rs 50,000 in a 8 per cent tax-free bond, he gets Rs 4,000 tax-free interest every year, but, the interest earned on reinvesting it will be taxable at 30 per cent. These reinvestments, whether in a bank FD or in other fixed income instruments, will be at in terest rates prevailing in the future, which may be higher or lower than the present rates.

In a 10-year bank FD paying 9.75 per cent, the reinvestments of interest will take place at 9.75 per cent, though the interest earned on them will continue to be taxable at 30 per cent for the same investor.


Thus, if interest rates prevailing in the future are far lower than the present rates, then, the bond investor's returns at the end of 10 years, after reinvesting the tax-free interest at those low rates, may not surpass bank FD returns.


Key differentiators with FDs: Unlike in bank FDs, liquidity could be a problem in tax-free bonds, even though they are listed on stock exchanges. The traded bonds may not see enough buyers and sellers, and even otherwise, they may fetch you a market rate lower than the intrinsic value of your bond since interest rates may have fallen by then.

In terms of safety, these bonds may have an AAA rating now, but, there is no guarantee that it won't be downgraded later and pose a risk to your principal amount. 

 

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