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Jan 15, 2013, 03.28 PM IST | Source: Moneycontrol.com

Which is a better investment? Tax-Free Bonds or FDs

Investors are often seen confused when it comes to choosing between Tax free Bonds and Fixed Deposits. Choosing one between the two largely depends on investor’s goal as pros and cons exist in both the products. Read this space to know what factors differentiate these two fixed income instruments to take better investment decision.

IIFCL is the latest company to come up with tax-free bonds, and with a 20-year option they have made people think about them who would have other wise ignored tax-free bonds.

This is because while their utility for residents in the 30% tax bracket is quite clear, it isn’t so clear whether others who don’t have fall under the 30% tax bracket should also opt for them or should they just choose fixed deposits instead.

NRIs are one segment of the population in whose case this comparison becomes applicable because they can access NRE Fixed Deposits, which are also tax-free for them, and in general have a higher interest rate than tax-free bonds. 

Residents who are under the taxable income limit or pay 10% taxes are also one segment that has to make this decision.

Let’s look at some factors that you must consider while choosing between tax-free bonds and fixed deposits.

1. Interest Rates: The first factor is of course interest rate, and in this respect, fixed deposits have a clear edge on tax-free bonds because currently most banks give a higher rate on fixed deposits when you compare that with a tax-free bond of similar maturity.

2. Benefit of compounding: This is another area where fixed deposits score over tax free bonds because tax free bonds pay out interest every year and there is no benefit of compounding whereas in fixed deposits your interest usually gets compounded every quarter.


3. Reinvestment risk: Once again, fixed deposits do better than tax-free bonds because you have the option of reinvesting interest income back in the fixed deposit at the same rate whereas you are paid out interest annually in the case of tax free bonds, and you have to take care of investing the interest income yourself. This is a big factor if you don’t need the interest income every year and would much rather have a bigger lump sum amount at the end.

For example, a 9.00% fixed deposit for Rs. 1 lakh that compounds quarterly for 10 years will yield Rs. 2,43,518 at the end of 10 years whereas if you put the same amount in a tax free bond that gives out 7.69% interest like IIFCL then your interest earned in the ten years would be Rs. 76,900 and you will get Rs. 1,00,000 back at maturity.

This of course ignores what you do with the annual interest, and the time value of money, but for people who would much rather get a bigger lump sum at the end of the tenure because they don’t have a near term need for money, this is an important factor to consider.

4. Liquidity: I feel that as far as liquidity is concerned, tax-free bonds have a slight edge over fixed deposits. If you want to break your fixed deposit early then you have to pay a certain penalty in the form of a reduced interest rate but in the case of tax-free bonds you can sell them in the secondary market and if interest rates go down then the bonds will trade up. 

This market is not all that well developed right now, and you may face issues with selling a large amount of bonds, or if rates go up then you may have to sell your bonds at a discount but as far as the present situation is concerned, tax free bonds do seem to have an edge on bank fixed deposits as far as liquidity is concerned.

5. Tenure: IIFCL has come out with a 20-year bond, which has the longest maturity of any tax-free bond so far and gives you the opportunity to lock in a rate of 7.90% for 20 years. Banks don’t offer a fixed deposit of more than 10 years, and if you wanted to lock in to this rate for a very long time like 20 years then this tax-free bond is the way to go for you.

6. Capital Appreciation: Since bonds list on the market, and move in an inverse direction with respect to interest rates (they go up when interest rates go down and vice versa) there is a good chance that some of these bonds will give appreciate and give you capital gains when interest rates go down. The assumption of course is that we have seen the worst of the high interest rate scenario and rates will go down in the future from the levels we currently see.

Conclusion

There are pros and cons to both products and it largely depends on what you’re trying to do. If you have need for annual interest then the tax free bonds are probably better because they will pay you annually and you can sell them early to get capital gains if they appreciate.

On the other hand, if you want a bigger lump sum then fixed deposits are probably better as they allow you to build a bigger corpus and free your mind of reinvesting the interest income every year.

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