How to decide whether to invest in tax-free bonds or not
October, 19th 2015
Narayan, who is in his early forties, wants to invest in a fixed income product. His adviser has told him about some tax-free bonds issued by public sector companies. These are long tenure bonds, typically maturing after 10, 15 or 20 years and would make an ideal inclusion in his retirement portfolio.
Every year, interest/coupon will be paid out to Narayan and it will be tax-free income. The principal invested will be returned on maturity. These bonds will also be listed on a stock exchange, which would allow an option to investors to benefit from any appreciation in the price and exit before maturity. Narayan is wondering whether he should invest in such bonds.
Before he decides to invest, Narayan must weigh the pros and cons of tax-free bonds against other competing investments. As an investment providing tax-free income, the bonds fare well compared to bank fixed deposits and debt mutual funds. He must compute the effective pre-tax interest rate equivalent and compare. The higher his tax bracket, the higher will be the benefit.
In other words, if he falls in the 10% tax bracket, the benefit will not be much. Further, compared to other corporate bonds, these bonds will be highly rated in terms of credit quality. As government undertakings, the risk of default is minimal.
However, Narayan must bear in mind the really long tenure. If he thinks he will be able to sell it off on the stock exchange when interest rates drop and make handsome capital gains, he must also remember that selling such bonds may not be possible for retail investors like himself. These bonds are not traded frequently. He must be open to the possibility that he may be stuck with the investment for 10, 15 or 20 years. He must, therefore, ensure that he does not have a short-term goal associated with tax-free bonds.
Narayan must understand that his investment decisions should not be driven by tax considerations alone. He should not invest in tax-free bonds just because the interest is tax-free. He must follow the primary rule of investing— product choice should be driven by his financial goals. Taxfree bonds would be attractive for him if he falls in the higher tax bracket, is looking for regular income and has no concerns on liquidity.