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Saturday, January 25, 2014

Tax Free Bonds in India

Tax free bonds have emerged as highly popular investment option among investors due to the taxation benefit that they offer. These bonds, generally issued by government backed entities, are exempt from taxation on the interest income received from such instruments under the Income Tax Act, 1961.
What are Bonds?
Bonds form the part of "Debt" as an asset class. This implies that the investor has given a loan to the issuing entity, and will be repaid at the end of the tenure as specified. Bond, therefore, is an agreement between you and the bond issuing entity for a fixed tenure and a fixed interest on your investments.

Some facts about Tax Free Bonds
  • 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. A substantial portion of this money has come from institutional investors and high net worth (HNI) 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.
  • Tax-exempt bonds usually pay lower coupons than corporate bonds as they enjoy a better credit rating and the interest received is tax-free, thus after-tax returns work out to be higher for the tax-exempt bond.
  • If we have to compare these rates with fixed deposit rates, we should remember that returns from FDs are taxable in the hands of investors while these bonds are tax-free. So, one needs to look at returns from FDs after deducting the taxes. Currently, no bank FD pays such high rates. And if any company is offering such high rates, the same may not have such high ratings.

The merits
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.
 
Here are some key merits of investing in these tax free bonds:
  • Low risk of default, since companies have a better credit rating
  • Listing of bonds on various exchanges provides liquidity to your investments
  • Option of holding bonds in 'Demat Form' makes your investments easy to handle & monitor
  • Ratings by agencies like CARE, FITCH, CRISIL, ICRA enables you to assess the quality of instruments

Risk Vs Reward
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 (economy booms), you are in for capital gains as well. 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.

The flip side
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 in appropriate available options. 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.

How to invest
  • Public Issue: During the public issue of the bonds, you can invest in them by submitting a physical form furnishing the details as requested.
  • Exchange: Post the public issue; these bonds are listed on NSE or BSE or at times on both. You can invest in these bonds through your Securities trading account the way you invest in shares.

Get going, this is one debt based investment in your portfolio which is not worth missing.

Cheers


Manoj Arora
Freedom can buy you what money cannot !!

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