ARE TAX-FREE BONDS A GOOD BET?

By Ruma Dubey

The Indian IPO market is dead but the Indian bond market seems to be action packed, like a 007 movie! The market seems to be inundated bond issues , more so tax-free bonds. Beginning in September with REC, there was HUDCO and currently three more tax free bond issues are open for subscription – IIFCL, PFC and NHPC.

India has a high savings rate and people tend to constantly be on a look out for better investment avenues. People are sitting on money, they need options. And in these tumultuous times, when there is no appetite for risk, these bonds are fast emerging as the safer havens. Tax free bonds, as the name suggests, offers a tax free on the interest earned. Something akin to the money which we invest in PPF account, the interest income remains tax free and it is an instrument mainly to save tax too! After taxation, the yield which one gets, is almost same as that money earned in these bonds, which on face value might be giving you a lesser interest rate.

The tax free bond issue of Power Finance Corporation (PFC) closes on 11^th November and its 15 year (Series 2) bonds were comparable to 12.72% pre-tax return earned on other fixed income instruments, assuming the highest tax bracket of 30.9% for retail individuals. The other tax-free bond issue from IIFCL closes on 31^st Oct and its 15 year (Series 2) bonds were comparable to a 12.49% pre-tax return earned on other fixed income instruments, assuming the highest tax bracket of 30.9% for retail individuals. Compared to these, the post-tax income earned from Fixed deposits comes at a much lower rate and works to around 9 to 8.5% in most of the offerings.

Compared to last year, the tax free bonds are also coming at much higher rates. Like PFC’s tax free bonds, which were offered in 2011 were at 8.3% pa for 15 years tenure and 8.2% pa for 10 years tenure. In 2012, the 15 years tenure paid much lower at 7.86% pa and 10 years at 7.69% pa. Similar is the case with IIFCL as well as NHPC. Thus currently these tax free bonds earn you the best returns when compared with FDs or other debt instruments.

The there is the question of liquidity. These bonds get listed on the stock exchanges, some on both NSE and BSE while most on just BSE. This means that you can sell the bond in the secondary markets without worrying of a penalty in FD, when broken before the tenure. But those who had invested in the earlier tax free bonds might have a rethink, as most of those bonds are today quoted below their issue price. And this is because the new bonds offer higher yields and thus fancy for the older bonds with lower yields in waning. The earlier 10-year bond issue of PFC is today quoted at Rs.960 v/s face value of Rs.1000 and that of REC is at Rs.962. IIFCL is at Rs.980 and worst performing is Indian Railway Finance Corporation, which is at Rs.953 levels. Thus today, those looking to get out of older bonds will have to do so at a loss. Also one has to remember that volumes are very low on these counters. You may want to get out of an older bond but finding a buyer might be very difficult.

Two questions thus arise – should one buy these older bonds being quoted at a discount and should you buy these bonds only for the sake of liquidity? Answer to both the questions – NO. Even at discounted prices, the yield-to-maturity rate is not as attractive as the ones currently on offer thus makes no sense to invest only because it is available cheap. Secondly, liquidity cannot be the criteria at all for investing in tax free bonds. In fact they are not as liquid as they seem, with no buyers on the counter, making it difficult for one to sell. Also many in the market that prices quoted are rarely the ones at which actual trades take place as most of the times, it is sold on “negotiated” prices like in olden days – through a broker and not online.

Another point in favour of tax free bonds is that it does not have TDS. In FDs, when your interest income goes above Rs.10,000,a TDS is cut  but here, in tax free bonds, there is no TDS.

Tax free bonds score higher in all aspects, except one – capital gains. As per provisions under section 2 (29A) of the Income Tax Act, read with section 2 (42A) of the Act, a listed Bond is treated as a long term capital asset if the same is held for more than 12 months immediately preceding the date of its transfer. Under section 112 of the said Act, capital gains arising on the transfer of listed Bonds shall be taxed @ 10% without indexation. And short term capital gains tax is also applicable as per your tax slab.

At a time of heightened uncertainty and higher tax regime, tax free bonds are a safer haven, with more earning propensity. And if you come into the higher taxation slab, are a HNI, tax free bonds is then a must!