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Are tax free bonds beneficial to investors?
October, 25th 2013

Rajiv Raj In recent times, tax-free bonds have caught quite an investors’ fancy. What is interesting to note is though many government owned institutions came out with tax-free bonds, the recent success of Power Finance Corporation ’s tax-free bond issue attracted the attention of many an investor. The issue attracted bids worth Rs 2332 crore on the first day of opening, whereas its issue size is of Rs 3875 crore. More so, a substantial portion of this money has come from institutional investors and high networth individuals who represent the smart money in financial markets.

Tax free bond issue of National Hydroelectric Power Corporation too got good response on day one. Investors’ interest in these tax-free bonds is not unjustifiable. There is a convincing logic behind it. Take for instance the case of PFC issue or the NHPC. Both are tax-free issues with 20-year tenure and offering 8.92% coupon rate each year to investors. If you belong to the high income tax bracket this is a very tempting proposition. You are making money and besides there is no credit risk since they have government backing. So, you know that you are going to get your capital back on the date of maturity.

But most of us don’t understand the intricacies of the bond markets. We play safe but often we miss on the smartness of the move. Most of us believe that opting for a long duration bond is a smart move. But it need not be so. There are factors beyond that, which when observed closely and implemented swiftly can provide you reasonably good returns. We know that these bonds are listed on stock exchange.

This throws open an option to play interest rate cycle in Indian economy. If you expect the interest rates to go down, buy an AAA rated bond for 20 years term and remain invested in the bond. Over the next one year, you will take home tax-free interest on this bond and if the interest rates come down, you are in for capital gains. So over a period of time, there is a high possibility that you should take home handsome returns, with no stock market risk and no credit risk.

While Indian investors make the most of this opportunity, the global Indian Diaspora should not remain behind. Investors outside India, non-resident Indians, should take this opportunity to invest money in Indian debt instruments. In case of tax-free bonds, you are not taking stock market risk and there is no credit risk also. If you comfortable with forex risk, this is a wonderful opportunity, which you should not let go.

However, there is a downside which investors should be aware of. If you are investing in these bonds, you may not get the opportunity to invest in periodical interest at the same tax-free interest rates that are offered to you today. There is no compounding option available with these bonds. So you have to be disciplined enough to ensure that you invest the periodic coupon payments. Otherwise it will be lost somewhere in your bank statements. If you are a retired person or nearing retirement and wondering where to invest your money, these bonds are wonderful investment option. Some of your fixed income asset allocation should be towards these bonds. So, why delay!

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