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Tax-free bonds a safe haven for investors
August, 21st 2013

The season of tax-free bonds is here. With the government allowing state-owned companies to issue tax-free bonds in the first half of the financial year, these will soon be competing with fixed deposits and other debt instruments.

Some of the public undertakings that will be raising funds are IIFC, IRFC, PFC, NHAI, Hudco, REC, NTPC, NHPC, Indian Renewable Energy Development Agency, Airports Authority of India and Cochin Shipyard. Together, these entities are looking to raise Rs 48,000 crore.

This should be good news for investors, since 70 per cent of these bonds are reserved for public issuance. Of this, 40 per cent will be reserved for retail investors. In addition, with both equities and the debt market going through a rough phase, it will give them a safe investment option.

Raghvendra Nath, managing director of Ladderup Wealth Management, says as these are quasi-government bonds, they are safe to invest. And with G-Sec yields at an all-time high, if any company, comes out with a bond issue now, investors can look forward to high yields. “Since the G-Sec is around nine per cent, the yield on tax-free bonds, if issued now, could be around 8.5 per cent,” says Nath.

In comparison, banks are offering eight-nine per cent on fixed deposits (FDs) of one to five years. The five-year bank FDs offer tax exemption under Section 80C. However, the interest income earned on five-year FDs is taxed. In tax-free bonds, the interest income is tax-free but any capital gains on selling the bonds are taxed.

Fixed maturity plans (FMPs) of mutual funds, which give benefit of double inflation indexation, benefit are currently offering around 10-3-10.4 per cent, while a three-year FMP is offering around 9.8 per cent.

What works in favour of such bonds, especially for the risk-averse investor, is that these will be issued for long term (10-20 years), implying they will be earning a decent rate of return for a longer period.

Ashish Shanker, head (investment advisory), Motilal Oswal Private Wealth Management, says investors should definitely consider these tax-free bonds, since they will offer competitive yields.

However, a word of caution: Look at rating. “In the current environment, investors should be very concerned with the rating, because a 10-year period is very long. There have been cases where over long periods, even the best rated instruments have been downgraded,” says Sumeet Vaid of Ffreedom Financial Planners. His advice is to avoid papers, which are rated below ‘AAA’.

These bonds are better suited for investors in the higher-tax bracket, 20 per cent or above, as the yields fetch around 10.5 per cent pre-tax. For those in the 10 per cent tax bracket, corporate fixed deposits with high credit ratings are better options since the return from the tax-free bonds would be around 8.5 per cent, while the corporate FD would give 10-10.5 per cent though they are riskier.

Liquidity is an issue because there isn’t a strong secondary market and you may have to exit at a discount in case of an emergency.

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