Power Finance Corporation (PFC) is coming out with an issue of tax-free bonds worth Rs 700 crores. The issue opens on October 5, 2015 and closes on October 9, 2015. The issue is only for Rs 100 crores. PFC has an option to retain oversubscription for a further Rs 600 crores. We will see what that means later in this post.
Last week, we had an issue of NTPC tax-free bonds. The issue was oversubscribed 10 times on the first day itself. So, the demand is high for such bonds. PFC 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 in July 2015 and has come up with a public issue for the remaining Rs 700 crores.
40% of the public issue (i.e. Rs 280 crores) is reserved for the retail investors. In this post, I will discuss various term and conditions of the issue, interest rates on offer, taxation and whether you should invest in these bonds. If you want to know more about tax-free bonds in general, please go through the following post.
Apart from certain facts, the pros and cons of PFC tax free bond issue are same as the one for NTPC tax free bond issue. Most of the information will be same as in the post on NTPC Tax-free bonds.
PFC 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
Investors in the highest tax bracket stand to benefit the most.
Long term Bank fixed deposits are offering 8-8.5% 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 PFC 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 (7.11% instead of 7.36% 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 PFC tax-free bonds?
Yes, NRIs can invest in these bonds on both repatriation and non-repatriation basis. If you want to invest on repatriation basis, invest through your NRE or FCNR accounts. On the other hand, if you want to invest on non-repatriation basis, invest through your NRO account. For more on NRE, NRO and FCNR, please go through this post.
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.
NRIs from US won’t be able to apply due to Foreign Tax Account Compliance Act (FATCA) regulations.
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 my post on NTPC 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). There have been numerous examples when the rating agencies were caught sleeping while the company went bust. 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 67.8% stake in PFC. 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.
Capital Gains
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.
Tax Benefits
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.
A few points to note
- The issue is for Rs 100 crores, with an option to retain oversubscription for another Rs 600 crores. So, essentially, the offer size is only Rs 100 crores. Remaining Rs 600 crores is their discretion. Whether they will sell bonds for Rs 100 crores or Rs 700 crores depends on their interest rate outlook.
- If PFC management feels they can raise money at a lower interest rate at a later date (in FY2016), they may choose to stop allocation much before Rs 700 crores. Considering the Reserve Bank cut repo rate by 50bps and 10-year bond yields slid sharply subsequently, this is a serious possibility i.e. PFC may not raise the entire Rs 700 crores in this issue. The interest rate is same as NTPC offered last week. However, NTPC offered these rates before RBI cut rates. I personally feel PFC won’t raise entire Rs 700 crores in this issue.
Who should invest?
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%. Debt mutual funds offer indexation benefits are 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 terms, 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.
The allocation is on First Come First Serve basis. So, if you plan to apply, apply on the first day itself.
Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in
