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Tax- Free Bonds vs. Bank Fixed Deposits - Where to invest?
December, 05th 2012

Last year as many as 5 public sector companies raised approximately Rs. 28,000 crore by issuing tax-free bonds. Retail investors in these tax-free bonds have earned 12%-16% returns in the last 8-10 months of their investments.

The number of companies issuing these bonds this financial year has doubled to 10 and the amount these companies are allowed to raise has also been doubled to approximately Rs. 53,500 crore.

Some investors confuse these tax-free bonds with tax saving infrastructure bonds but actually tax-free bonds do not provide any kind of tax exemption to the investors. 'Tax-free bonds' are called so as the investors are not required to pay any tax on the interest income earned. Whereas, the interest on your fixed deposit or post office investments (except PPF) is subject to tax.

In these times of vastly available information about various investment products, many people want to compare these bonds with the most popular bank fixed deposits.

What makes tax free bonds attractive?

Higher effective after-tax returns: Tax-Free bonds are tax efficient as compared to the bank Fixed Deposits. Suppose you fall in 30% tax bracket and have invested Rs. 5,00,000 in a fixed deposit of State Bank of India (SBI) for 5 years earning 8.50% p.a. interest. The after-tax effective rate of interest on this FD would be 5.87% (8.50%*(1-0.309)). You may also call it as tax-free equivalent rate of interest. On the other hand, currently open REC tax-free bond issue offers 7.88% per annum rate of interest, which is equivalent to 11.40% effective before-tax rate of interest. So, you can either compare 8.50% with 11.40% or 5.87% with 7.88%. This comparison makes tax-free bonds a clear winner as far as the rate of interest is concerned. In actual terms, youll end up having Rs. 29,368 as the interest with your FD after one year as compared to Rs. 39,400 with tax-free bonds, a difference of Rs. 10,032 every year.

Scope of capital appreciation: We all know India is struggling with a high inflation rate and the interest rates have been ruling on a higher side. But, as the economic growth is falling, there is a strong possibility that RBI will soon start cutting interest rates in its forthcoming monetary policies. Whenever the interest rates come down, bond prices go up. In that scenario, there is no scope for FDs to result in any capital appreciation as FDs are not tradable and you cannot transfer the ownership of your FDs to anybody else in the market. At the same time, there is a scope of capital appreciation with tax-free bonds as and when the inflation and interest rates fall. These bonds are tradable and freely transferable to any of the interested buyer on the exchanges where these bonds are listed.

Liquidity: One more attractive feature of tax-free bonds is their liquidity. When you break your FD before the tenure gets completed, the bank either levies a premature withdrawal penalty or gives the applicable rate of interest for the period you hold the FD for. Tax-Free Bonds score over FDs in this department also. You can sell these bonds in the secondary market whenever you want, given there is a buyer for these bonds. Till date the liquidity has not been a big negative factor for tax-free bonds issued last year.

TDS on FDs: Fourth factor which goes against FDs is that your FDs allow the banks to cut tax whenever they pay you more than Rs. 10,000 interest in a year. Needless to say tax-free bonds attract no tax so no scope of any TDS.

Forthcoming Tax-Free bond issues might not be able to match its past performance, but with RBI cutting interest rates, they should deliver good returns. Also, these instruments offer good investment opportunity for investors in the higher tax brackets (30% and 20%) or high-net worth individuals (HNIs).

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