Rural Electrification Corporation (REC) has come out with an issue of Rs 700 crores. The issue opens on October 27, 2015 and closes on November 4, 2015. In the past month, we had such tax-free bond issues from Power Finance Corporation (PFC) and National Thermal Power Corporation (NTPC). Both the issues got over-subscribed on the first day itself. With interest rates expected to decline further, there is heavy demand for those bonds.
To be honest, there is nothing new in this post. All the aspects including who should invest in such bonds have already been covered in the previous posts on tax-free bonds from NTPC and PFC. This post will cover a few features of this REC tax-free bond issue. Remaining portion will be same as other posts on tax-free bonds.
To know more about tax-free bonds, especially taxation on sale of such bonds, please go through this post.
REC was allowed to raise Rs 1,000 crores by the Government in FY2015-2016. The company has already raised Rs 300 crores by way of private placement and has come up with a public issue for the remaining Rs 700 crores.
REC Tax-Free Bond Issue: Salient Features
Bonds will be issued on First Come First Serve (FCFS) basis. The bond will be available in three maturities i.e. Series I (10 years), Series 2 (15 years) and Series 3 (20 years). The issue size of Rs 700 crores is for all the series combined.
Interest Rate/ Coupon
The interest rate offered on these bonds is lower than the rates offered on PFC and NTPC bonds. This is because interest rates have softened post the RBI rate cut last month.
Investors in the highest tax bracket stand to benefit the most.
Long term Bank fixed deposits are offering 7.5-8.5% p.a. currently. SCSS interest rate as notified by the government for FY2016 is 9.3% p.a. These are pre-tax yields. If you compare these yields with pre-tax yields of REC tax-free bonds, there is nothing in these bonds for investors in 10% tax slab. Such investors will in fact do better investing in FDs and SCSS (only senior citizens).
An additional point to note is that investment in SCSS and 5-year tax saving FDs (not all FDs) comes with tax benefits under Section 80C too. There are no tax benefits on investment in tax-free bonds under IT Section 80C. Even investors falling in the higher tax brackets should consider this aspect, especially if you are not utilizing the complete limit of Rs 1.5 lacs under Section 80C.
For more on Senior Citizen Savings Scheme (SCSS), please go through the following post.
Please note that by investing in these bonds, you can lock in the interest rate for the long term. It is a valid argument. You will not find a fixed deposit of tenor greater than 10 years. SCSS maturity is five years with an extension option for another 3 years. I cannot speculate on the direction of interest rates in the future. Interest rates go through up and down cycles.
Who qualifies as a Retail Investor?
A retail investor can invest up to a maximum of Rs 10 lacs (face value) in these bonds. If you hold these bonds worth more than face value of Rs 10 lacs (on the record date of payment of interest), you will not be classified as a retail investor and will get a lower coupon (7.09% instead of 7.34% for 10 year maturity).
Thus, you can get higher coupon rate if you hold no more than 1000 of these bonds. Please this is the aggregate number across all the series of this bond. Hence, to be classified as a retail investor, you cannot hold more than 1000 bonds across the three schemes. Your PAN will be used to aggregate your holdings and determine if you are a retail investor.
Can NRIs invest in REC tax-free bonds?
Yes, NRIs can invest in these bonds on only non-repatriation basis. However, NRIs can stay away from these bonds.
NRIs can get similar or better interest rates in NRE fixed deposits. Interest on NRE fixed deposits is tax-free too. So, there is no real benefit of investing in these tax-free bonds.
You can argue that high interest rates can be locked through these bonds for the longer term. Well, interest rates move in cycles. The rates currently on offer are lower than rates offered on similar bonds a few years back. Invest in NRE FDs for 3-5 years. Wait for a few years. When your FD comes up for renewal or even in the interim, you may even get better rates. I don’t know. Nobody knows.
Credit Rating/Credit Quality
CRISIL, ICRA and CARE have given AAA rating to long term borrowing programme of the company, which is the highest rating that can be given to any debt instrument.
As I mentioned in earlier posts on tax-free bonds, I do not take much comfort from these ratings as the rating agencies are almost always late (at least as far as corporate debt is concerned). I will not comment on the company financials as I do not have the requisite expertise. You are requested to do that analysis on your own and not rely on credit ratings.
The Government of India holds almost 60.4% stake in REC. I hope the government will come to the rescue of bond holders if company finds it difficult to meet the obligation. Please note the Government of India is not obligated to do so. This is just my hunch. So, I do not really worry about default from the company.
Exit before maturity (Liquidity Risk)
The bonds will be listed on Bombay Stock Exchange (BSE). However, given the size of the issue and low volumes in bond trading in India, the exit in the secondary market won’t be so easy. Liquidity will be very low.
Lower liquidity also leads to higher bid-ask spreads. So, if you are looking to exit in the secondary market, you might have to exit at a price lower than the intrinsic value.
If you hold the bonds till maturity, there is no question of capital gains.
Bonds prices and interest rates move in opposite directions. When the interest rates go up, bond prices go down. On the other hand, when the interest rates go down, bond prices go up. So, if you expect interest rates to go down in the future, you can invest in these bonds for potential capital gains too.
However, do keep the liquidity risk in mind if you are betting on favourable interest rate movement.
Interest on these bonds is tax-free.
No tax benefit on the investment amount under Section 80C.
If you sell the bonds before one year, short term capital gains will be taxed at your marginal income tax rate (as per your income tax slab).
If you sell after one year, long term capital gains will be taxed at a flat 10.3% (including cess). Please note there is no indexation benefit available for listed bonds such as these, which is a negative for tax-free bonds. You can go through this post for comparison of tax treatment of tax-free bonds, debt mutual funds and fixed deposits.
Who should invest in REC Tax-Free Bonds?
Investors falling in the higher tax brackets and looking for regular income can look to invest in these tax-free bonds.
Investors in the 10% tax bracket should obviously not invest.
Only those who seek to hold the bonds till maturity should invest. Exit in the secondary market won’t be that easy or at a favourable price. Additionally, capital gains on tax-free bonds are taxed at flat 10%. There is no benefit of indexation. Debt mutual funds offer indexation benefits after 3 years.
For senior citizens or retirees, do explore other options such as SCSS or Senior Citizen Fixed deposits before deciding to invest. Do understand SCSS and 5-year fixed deposits come with 80C benefits while tax-free bonds don’t offer any tax benefits under 80C.
If you are not looking for regular income, don’t invest in these bonds. Firstly, you don’t get the benefit of compounding. Secondly, if you are willing to lock in your money for such long term, equity mutual funds can offer you better tax-adjusted returns. The returns under equity funds are not guaranteed but if you invest with discipline through SIPs, you should get better results.
Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in