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Why tax free bonds are a good investment option

Lovaii Navlakhi discusses some good tax free bond investment options. He also lists things that need to be done before choosing to invest in a bond issue.

September 25, 2013 / 03:49 PM IST

Lovaii Navlakhi
International Money Matters

Last financial year, the tax free bonds were mostly a no-show with very few investors biting the bullet. This year however things look different.

First, these bonds are going to come out earlier in the Financial Year as opposes to Feb-Mar last financial year. This will definitely allow one to plan and invest.

Second, with the 10-year benchmark yield having risen high (it even touched 9 percent), coupon rates will be very attractive. A bond can offer a coupon rate upto the govt bond rate minus 80 basis points.

Also read: Know more about Savings Bank interest rates

For e.g. if the govt bond rate is 9 percent, then these bonds can offer upto 8.2 percent. For retail investors, like you and I, there is an added advantage as these bonds (only those with AAA rating) can offer upto 8.45 percent i.e. 55 basis points lesser than govt bond rate.

Now because these bonds are tax free, the interest you earn from them is completely tax free. So a tax free bond offering a coupon rate of 8.45 percent is actually equal to another fixed income investment that offers a return of 12.06 percent, if you are in the 30 percent tax bracket!

The first tax free bonds to be launched by REC last week has the following yield for retail investors – 8.26 percent, 8.71 percent and 8.62 percent for 10, 15 and 20 years respectively; for HNIs  8.01 percent, 8.46 percent and 8.37 percent respectively for 10,15 and 20 years. Minimum investment required is Rs.5000 - 5 bonds of Rs.1000 each.

This is just the beginning as such bonds will be launched by truckloads soon as 13 PSUs are set to raise Rs.48,000crore from these bonds

What you need to consider before investing in such bond issues is

- Your tax bracket – if this is 30.9 percent, on a gross basis, the coupon on these bonds is equivalent to a pre-tax interest rate of around 12.0-12.5 percent hence definitely attractive especially when you add in the fact that the risk of default is minimal.

- Your Asset Allocation - Don’t stray away from your asset allocation because of these bonds. If you already have enough/required exposure to long term debt, then there is no need to invest in these bonds

- Liquidity - Remember that liquidity is low here as all these bonds will bear fruit only if held to aturity which is 10, 15 or 20 years. Having said that these bonds are tradable in the secondary market but such a sale may not always go your way and there is a new element of capital gains tax. So if you have an intention of liquidating the bonds, go for companies which will list the bonds on BSE and NSE.

- Rating of the bond – Most of these bonds will have AAA or AA rating. As all of companies issuing these bonds are government enterprises, there is no default risk. So you could take advantage of the yield difference by putting money in AA+ companiesvs AAA companies.

All in all tax free bonds are a good option for long term investors who haven’t taken much exposure to debt through the usual routes of EPF, Insurance policies, PPF etc.

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