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Tax Investments - Tax-Free Bonds

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There are currently two tax-free bonds, the first one is Housing and Urban Development Corporation (HUDCO), which is rated as AA+, which has been extended now till 1st February. The coupon rate have been offered for the retail investors where the retail investors have been defined as those investors who invest upto and including Rs 10 lakh in the bond. So, the coupon rate for the retail investors for 15 year option in HUDCO is 8.01 percent and for the 10 year option is 7.84 percent.

The second is IRFC, which is AAA rated bond issue. Here, the coupon rate offered to retail investors for a 15 year term option is 7.84 percent and for the 10 year it is 7.68 percent.

As far as the relevance of the tax-free bonds n portfolio is concerned we need to really look at what exactly investors have in the debt portfolio. It can be divided in two parts; on one hand you have traditional investment options like provident fund (PF), public provident fund (PPF), bonds, debentures and fixed deposit (FDs). The major attraction there is one that there is a guaranteed rate of return and the second is a relative safety of investments. On the negative side there is that the interest which is earned barring exceptions like PF or PPF it is all taxable. So, the real rate of return or the post tax return is very low. The real rate of return ofcourse is the nominal return minus inflation and minus taxes.


On the other hand, you have market-linked instruments like debt funds. Since we are talking about the long-term investment options, in the current rate scenario when the interest rates are set to go down we can look at income funds or dynamic bond funds. Now because there is an inverse relationship between interest rate and the bond prices investors can get good returns here and major attraction also there is that these are more tax efficient as compared to traditional investment options.


With regards to tax-free bonds, they are better of these two. One is, they are quite safe because these bonds are issued by the Government of India undertaking. So, they are quite safe. The second is the returns are guaranteed and returns are quite attractive too. The fact that these returns are tax-free really makes it very attractive. Now for example if you look at HUDCOs, if you are talking about 8.01 percent 15 year option, for a highest tax bracket investor the pre-tax comes to around 11.6 percent. There aren't many options which will give you this kind of return for a period of 10-15 years.


I believe that tax-free bonds have to be a part of every investor's portfolio and also another concern the investor have is of liquidity. Now these bonds are usually listed on the one exchange or both the exchanges, so there is reasonable liquidity

Even if that average is around 9-10 percent or maybe even 10 percent, the fact is that not every investor can manage the portfolio very actively. Looking at the returns, even if you just leave the investment in those income funds, you are going to see huge variations there. So, I believe that there is a scope for every kind of investment in the portfolio. It should not be only traditional option or it should not be only income option. You can have a mix of these two.

In that context I believe that these bonds definitely have a place in the portfolio because you are assure of what you are going to get for the next 10-15 years, However, investors have to be very careful in terms of how much they allocate these. You cannot allocate the money which you have kept aside for equities because over a period of 15 years equities will definitely give better returns.

There is a provision here that if the original allottee who happens to be in the retail segment and as I mentioned earlier, all those investors who invest upto including Rs 10 lakhs in these bonds are termed as retail investor. If the original retail investor sells his bonds in the secondary market, the subsequent buyer will get 0.5% less, which is equivalent to the rate which is being offered to HNIs and qualified institutional buyers (QIBs). Basically, the rate gets equated with other three categories of investors.

If the transfer happens because of death of original holder and goes to the legal heir then there is no change here. Definitely, in that case there is half percent less. However, I believe it can affect the liquidity to some extent because the new retail buyer will not find it very attractive. But the fact is that there maybe demand from the institutional investors because we have seen the trend that is there is more inflows coming from the institutional than retail in these bonds.

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