 "Minimise investment risk through tax-free bonds")
In the current financial year, public sector companies will raise a total of Rs 40,000 crore through tax-free bonds. Indian Railway Finance Corporation (IRFC) issue will hit the market soon and the coupon rate is expected to be around 7.15 per cent, according to reports. Recently, NTPC concluded one such issue with a coupon rate of 7.15 per cent for and 10-year tenure. The company was targeting Rs 300 crore. The investors lapped up the issue and the company received bids for Rs 2,175 crore - an oversubscription of 7.25 times.
There's a good reason for investors' frenzy. Amidst the options a person has in debt instrument, tax-free bonds offer a distinct and lucrative opportunity. These instrument offers diversification, have higher post tax returns and give regular income. In the falling interest rate environment, which we are experiencing at present, they help an investor to lock-in his or her investments for the long term.
The interest earned from tax-free bonds do not form part of the total income and therefore they are exempted from tax, according to provisions of Section 10 (15) (iv) (h) of Indian Income Tax Act, 1961. But their benefits are not just restricted to tax.
Liquidity: They are listed on stock exchanges and provide an easy exit option. However, a person needs to be aware of capital gains or losses arising out of sale of these bonds before trading in them.
Capital safety: As these bonds are issued by government-backed institutions, they generally have better credit ratings, which further helps in reducing the investment risk. Investing in them is akin to putting money in a State Bank of India fixed deposit.
Capital gains: In a declining interest rate scenario, these bonds generate higher capital gains since the price of the bond is inversely related to interest rates. The vice versa can also hold and hence it is advisable to take financial advisors' view on the interest rate scenarios before committing to these bonds.
The rate of interest offered on these bonds also depends on the credit rating of the issuing company. The coupon rate for an AAA rated company's bond can be lower than the yield of a similar maturity government bond with lower rating. This, in effect, means that the interest rate will increase with lower credit ratings of the issuer.
Should you invest?
Although these bonds suit almost all types of investors, individuals in the higher tax bracket benefit the most, that is, those in the 20 per cent tax bracket or more. These bonds are further useful for those who want to invest in low-risk, regular income, and long tenure papers. But in the environment where interest rates could come down going forward, it can suit categories of investors. The interest is paid annually and transferred directly to the investor's bank account.
These bonds are also open for subscription to Hindu Undivided Families (HUF) and sometimes to even non-resident Indians (NRIs), with a small compromise in the offered interest rate.
As per the Central Board Of Direct Taxation circular, retail investors, HUF and NRI (only on repatriation basis) can invest in the tax-free bonds up to Rs 10 lakh. Any investor, whose investments in such bonds is above Rs 10 lakh will be considered as high net worth individuals (HNI) and the interest rates will be 0.25 per cent less as compared to rates applicable for retail investors.
Why you shouldn't
A person, who is in the lower tax bracket, should carefully consider investing in them. With limited disposable income, they should rather consider investing in other options, which offer better returns depending on their risk appetite. For example, investing in mutual funds through a systematic investment plan should be their first priority for wealth creation.
These bonds don't suit investors who are looking to invest for a short duration. They do have exit options once listed on stock exchange. But the pricing will depend on lot of factors. At present, the economy seems to be in a downward interest rate cycle. But if it was in a rising one, it's better to look at other avenues within debt.
Time horizon
These instruments are usually issued for long term tenures of 10, 15, or 20 years. These bonds are listed and provide flexibility to the investor to sell when required. However, liquidity may not be available due to its long term nature. It should be noted that, although interest income generated is tax-free, the capital gains are not. That means if you sell them mid way, you will need to pay taxes. Short term capital gains (held less than three years) are added to your income, while long term capital gains (when held for more than 36) are taxed at 20 per cent with indexation.
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There's a good reason for investors' frenzy. Amidst the options a person has in debt instrument, tax-free bonds offer a distinct and lucrative opportunity. These instrument offers diversification, have higher post tax returns and give regular income. In the falling interest rate environment, which we are experiencing at present, they help an investor to lock-in his or her investments for the long term.
The interest earned from tax-free bonds do not form part of the total income and therefore they are exempted from tax, according to provisions of Section 10 (15) (iv) (h) of Indian Income Tax Act, 1961. But their benefits are not just restricted to tax.
Liquidity: They are listed on stock exchanges and provide an easy exit option. However, a person needs to be aware of capital gains or losses arising out of sale of these bonds before trading in them.
Capital safety: As these bonds are issued by government-backed institutions, they generally have better credit ratings, which further helps in reducing the investment risk. Investing in them is akin to putting money in a State Bank of India fixed deposit.
Capital gains: In a declining interest rate scenario, these bonds generate higher capital gains since the price of the bond is inversely related to interest rates. The vice versa can also hold and hence it is advisable to take financial advisors' view on the interest rate scenarios before committing to these bonds.
The rate of interest offered on these bonds also depends on the credit rating of the issuing company. The coupon rate for an AAA rated company's bond can be lower than the yield of a similar maturity government bond with lower rating. This, in effect, means that the interest rate will increase with lower credit ratings of the issuer.
Should you invest?
Although these bonds suit almost all types of investors, individuals in the higher tax bracket benefit the most, that is, those in the 20 per cent tax bracket or more. These bonds are further useful for those who want to invest in low-risk, regular income, and long tenure papers. But in the environment where interest rates could come down going forward, it can suit categories of investors. The interest is paid annually and transferred directly to the investor's bank account.
These bonds are also open for subscription to Hindu Undivided Families (HUF) and sometimes to even non-resident Indians (NRIs), with a small compromise in the offered interest rate.
As per the Central Board Of Direct Taxation circular, retail investors, HUF and NRI (only on repatriation basis) can invest in the tax-free bonds up to Rs 10 lakh. Any investor, whose investments in such bonds is above Rs 10 lakh will be considered as high net worth individuals (HNI) and the interest rates will be 0.25 per cent less as compared to rates applicable for retail investors.
Why you shouldn't
A person, who is in the lower tax bracket, should carefully consider investing in them. With limited disposable income, they should rather consider investing in other options, which offer better returns depending on their risk appetite. For example, investing in mutual funds through a systematic investment plan should be their first priority for wealth creation.
These bonds don't suit investors who are looking to invest for a short duration. They do have exit options once listed on stock exchange. But the pricing will depend on lot of factors. At present, the economy seems to be in a downward interest rate cycle. But if it was in a rising one, it's better to look at other avenues within debt.
Time horizon
These instruments are usually issued for long term tenures of 10, 15, or 20 years. These bonds are listed and provide flexibility to the investor to sell when required. However, liquidity may not be available due to its long term nature. It should be noted that, although interest income generated is tax-free, the capital gains are not. That means if you sell them mid way, you will need to pay taxes. Short term capital gains (held less than three years) are added to your income, while long term capital gains (when held for more than 36) are taxed at 20 per cent with indexation.
The writer is CEO & Founder Right Horizons