Here's why you should opt for tax-free bonds

Juzer GabajiwalaVentura Securities

Although bonds may not appear as glamorous and action-packed as stocks, there are a number of reasons why you may want to include them in your portfolio. Well chosen bonds offer a safe haven for your money and are relatively liquid. Best of all, they usually offer good returns, especially if they are tax free.

Also read: Understanding tax implications of debt funds

Bonding with bonds

Bonds refer to debt instruments, which are issued with the purpose of raising capital by borrowing. They usually carry a fixed coupon rate but their value moves inversely with interest rates. Accordingly, if interest rates decline, the value of a bond will rise and vice versa.

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Juzer Gabajiwala

Director|Ventura Securities

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Government backed bonds are considered the safest type of investment as they carry a near zero risk and the rate offered on them is considered a benchmark for other issuers of bonds. Companies with AAA rating are allowed to offer 55 basis points (bps) less than the reference government bond rates.

Bonds are generally classified as taxable bonds and tax-free bonds.

Tax-free Bonds

Tax free bonds have emerged as a highly popular investment option among investors due to the taxation benefit that they offer. Unlike fixed deposits, NSCs and other bonds, the interest earned from these bonds is tax free. 

Tax-free Versus Taxable Bonds

Let’s compare the recent issue of REC tax free bonds, which offered a tax free return of 8.71 percent per annum with an SBI bond trading in the bond market at a yield to maturity (YTM) of 9.77 percent for a time horizon for 15 years. Is it better to opt for the tax free bond or the SBI Bond? The crux of the decision lies in the tax bracket into which the investor falls. While an investor in the 30 percent tax bracket will benefit from the REC Bond, someone who is in the Nil slab will find the SBI Bond more attractive.

Ratings

Another important feature that you should examine before investing is the bond’s rating. For instance, between an India Infoline Finance Limited (IIFL) AA rated taxable bond, which is available at a YTM of 12.70 percent and a AA+ rated HUDCO tax-free bond offering 12.67 percent pretax (tax-free – 8.76 percent), one should opt for the HUDCO bond since it has a AA+ rating. Then again, they are not strictly comparable as the tenure for both these bonds is different; HUDCO’s is for 15 years whereas IIFL’s is 5 years.

Liquidity

If you do not wish to hold a bond until its maturity, you can always sell it in the secondary market for bonds (NSE and/or BSE) and book profits. The liquidity of a bond depends on its trade volumes after listing. However, to be on the safe side, you should give preference to companies that are planning to list on both the BSE and the NSE.

While the short term capital gains from such a sale will be taxed as normal income, the long-term capital gains will be taxed at 10 percent (without indexation) or 20 percent (with indexation), whichever is less. The bonds must be held for at least 12 months for the profits to be treated as long-term gains.

Tax free bonds in the pipeline

The government had allowed 13 institutions, including NTPC, National Housing Bank and HUDCO, to raise Rs. 48,000 crore through issue of tax free bonds to boost long term infrastructure finance.

The chart gives the details of companies and amounts approved for raising money through tax-free bonds for the current financial year (2013-14).

The latest offerings will have the option of a 20-year term. Long duration bonds are more advisable as they reduce the reinvestment risk and offer higher coupon rates than 10-year bonds.

Buying bonds

All things considered, bonds offer a robust investment avenue. However, your investment choice should be based on your cash-flow requirements and the tax bracket into which you fall.

The author is the director of Ventura Securities.