Hindsight of Investing in Tax Free Bonds!

Ramesh is worried about to make fresh investment as interest rates going southwards, which is bad news for many savers , including senior citizens. Being a conservative investor, he has never looked beyond fixed deposits for his savings. Ramesh keeps evaluating bank FD interest rates for locking his funds for more than five years. But it is difficult now for him to get more than 8% pa for long-term FDs from banks. He is earning more than Rs10 lakh annually and hence, he is in the highest tax bracket (30%) which leads his effective post-tax yield from FDs is left 5.6%p.a. only.  Now, he wants to explore the option where he could be able to get post-tax yield above 8% pa from fixed income instruments. It can be possible only through investing in that instruments which give a tax-free income. Like Ramesh, many conservative savers are always looking for risk free and tax free instruments to beat the return of bank fixed deposits. Today, NHAI Tax-Free-Bonds 2016 may be a lucrative option for those savers. NHAI Tax-Free-Bonds is carrying 7.69% tax-free interest for a locking the funds for a 15 year bond. Though, these bonds is offering net post effective tax yield beyond 9% pa, every conservative investor needs to understand pros and cons before investing in  tax-free bonds to assess whether they really suit them or not.  This post gives you an overview of Tax-Free-Bonds and hindsight of investing in these bonds.

Long-Term but not compounded

Even current tax-free bonds are giving tax-free income and having longer tenure, investor should know that these bonds would not get benefit of compounding effect at their coupon rate. Every savvy investor should recognize that compounding factor is the eighth wonder of world in the investing parlance. If you invest the sum of Rs 1 lakh @ 7.69% p.a. in the bond for 15 years with annual compounding effect, you would get Rs 3.04 lakh which would give you a post-tax-yield @ 10.98% pa. Since current tax-free bonds will not get benefit of compounding, their interest shall compulsorily be paid out annually till the maturity of bonds. Hence, you will get post-tax yield only @ 7.50% p.a. on these bonds, even below currently coupon rate @ 7.69% p.a. due to non-availability of compounding factor on these bonds. So, tax-free-bonds are not suited for those who want long term wealth creation. Hence, if you seek regular income, then these bonds may be suited for you. Long-term investors looking to invest for the tenure of 10, 15 and 20 years may find better options in equity mutual funds.

Re-investment Risk

As outlined above cumulative FD does not carry interest re-investment risk. It assures you that the quarterly interest which has to be compounded and is re-invested at the same interest rate, to help you increase the yield. But Tax-Free-Bonds will pay you regularly yearly interest which you may want to plough back in a bank FDs or any other debt fund, which may not be available at same rate of interest or may be available at lower rate. If you want to earn on the interest income as well, you have to pay tax on that interest which will be lower your post-tax yield and the purpose of investing into the bonds is the almost defeated.

Liquidity Issue

Since these tax-free-bonds are available through demat form or physical form, you may need to maintain demat account for selling the bonds after holding them to meet the liquidity of funds before the maturity. On the other hand, the principal amount for these bonds is not guaranteed except at maturity. If you try to sell the bonds before the maturity date, you may get an amount higher or lower than the issue price, depending on the interest rates prevalent at that time. If you hold the bonds to maturity 10 to 20 years, you will get back the only issue price. If you are willing to hold the purchased bonds for the full term, the fluctuations in the interest rates should not bother you. If you do not plan to hold them to maturity, you may face liquidity crunch in secondary market while selling through exchanges since they are listed bonds, it becomes difficult to do so as they are not traded frequently. So, investors will have to hold them till maturity to get the tax benefit.

Tax on Tax-Free-Bonds

Though investing in tax-free bonds will not get any deduction under section 80C but the interest is automatically credited to your bank savings account and interest on the bonds is exempted from taxes. Moreover, there is no TDS deduction on annual interest earned on these bonds as interest is tax free. While the long maturity of the bonds, say 10 to 20 years may put you off, many may want to sell the bonds after holding them, say within year, will attract short capital gain tax and to be taxed as per your income tax slab. Unlike debt mutual funds, where you sell the bonds after 3 years, you would have to pay long-term capital gains which are taxed at 10% without indexation and 20% with indexation. However, you can avoid long term capital gains by investing under section 54EC.

Should you invest in Tax-Free-Bonds?

While fetching into these bonds, every investor should understand that investment decisions should not be primarily driven by tax considerations and should not interested to invest in tax-free-bonds just because the interest tax free. As outline above, one must weigh the pros and cons of tax-free bonds against other competing products. One should follow the primary rule of investing; asset allocation should be driven by his financial goals. Retirees and Senior Citizens who are in 20% or 30% tax brackets and seeking regular income can think about investing in these tax-free bonds.  Investors in the 10% tax bracket do not have much to gain by investing in these bonds. If you have time on your side and have long-term financial goals, say locking your money for 10-20 years, equity oriented investment avenues are the best option to realize your long-term financial goals, which may give you 12% to 15% p.a. in the long-run and also tax-free. Otherwise, you may be stuck with the investment for 10, 15 or 20 years. You must, therefore, ensure that you should not have a short-term goal associated with tax-free, tax-free-bonds.  Exit in the secondary market may not be as easy or at an unfavourable price. So, be prepared to hold the bonds till maturity if you are planning to invest.

 This article got published in Hindi Dainik Bhaskar on 12-04-2016

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