A series of tax-free bonds are expected to hit the markets soon. The Government of India has allowed seven PSU firms to raise Rs 40,000 crores in tax-free bonds this fiscal. Under tax-free bonds, interest/coupon is tax-free. Investors get the face value of the bonds back at the time of maturity of these bonds. Tax-free bonds present an attractive investment option for some investors because comparable pre-tax yield is much higher than fixed deposits or other taxable bonds. In this post, we discuss various features of tax-free bonds including eligibility, benefits, risks and tax treatment. We will compare these bonds against bank fixed deposits and debt mutual funds. Finally, we discuss whether you should invest in these bonds.
What are tax-free bonds?
Interest/coupon is tax-free. Face value of the bond will be returned to the investor on maturity. These bonds will also be listed on an stock exchange which offers an option to investors to exit before maturity.
Who can issue such tax free bonds?
For the financial year 2015-16, Govt of India has allowed seven public sector undertakings to raise Rs 40,000 crores through tax-free bonds. National Highways Authority of India (Rs 24,000 crores), Indian Railways Finance Corporation (Rs 6,000 crores), Housing and Urban Development Corporation (Rs 5,000 crores), Indian Renewable Energy Development Agency (Rs 2,000 crores), Power Finance Corporation (Rs 1,000 crores), Rural Electrification Corporation (Rs 1,000 crores) and NTPC (Rs 1,000 crores). Atleast 70% has to be raised through a public issue. Up to 30% can be raised through private placement.
Who can invest?
Retail investors (including individual investors, NRIs and HUFs) can invest. Qualified institutional buyers (QIBs), Corporate, partnerships, LLPs and High net-worth individuals (HNIs) can also invest. Retail investors can invest up to Rs 10 lacs in each issue. If you invest more than Rs 10 lacs in a particular issue, you will be classified as a High Net worth Individual (HNI). HNIs will be offered a lower interest rate/coupon than regular retail investors. This is discussed later in this post. The tenor of the bonds can be 10, 15 or 20 years. The choice of tenor shall be issuer’s discretion.
Central Bureau of Direct Taxes, through its notification dated July 6, 2015 has put a ceiling on the coupon/interest rate on the basis of reference government security (G-Sec) rate of the corresponding maturity.
PFC recently completed a private placement of its 10 years bonds worth Rs 300 crores at a yield of 7.16% p.a. So, you can expect coupon of 7.4% for 10 year bond in the public issue. Exact coupon offered will depend on prevailing G-sec rates and company discretion. Coupon rates for 15 and 20 year bonds are expected to be higher. Please note we have used 7.4% p.a. for illustration purposes in some of our examples. This does mean coupon offered on tax free bonds will be 7.4% p.a. You will have to wait for the corporate announcements to find the exact coupon rate on offer.
The rate offered this year will be lower than the coupon offered by PFC for same bonds in FY2013014. At the time, the coupon offered was 8.43% (10 years), 8.79% (15 years) and 8.92% (20 years). Interest rates have come down in the last two years. Thus, interest rates to be offered this year will be lower.
Benefits of Tax-free bonds
These tax free bonds offer far better returns as compared to fixed deposits. Since interest from FDs is taxable, 7.4% interest/coupon in these bonds is equivalent to 10.71% interest in fixed deposits (highest tax bracket).
It is easy to see the people falling in the higher tax brackets get greater benefits.
Bonds prices and interest rates move in opposite directions. If the interest rates fall further in the near future, investors will benefit from capital appreciation in bond prices. These bonds will be listed on stock exchange which provides a way for investors to exit before maturity. However, liquidity can be an issue if you plan to sell in secondary markets.
Additionally, by investing in these bonds, you will be able to lock-in tax free interest for the long term. This can be especially beneficial if the interest rates move down in the near future.
Credit Risk: There is credit risk involved i.e. if the issuing companies do not perform well financially, then there is a possibility that the company can default on its interest and principal payments. There is no sovereign guarantee on the issue. To give investors better idea about financials of the company, these bonds have to be mandatorily rated by two credit rating agencies before issuance. Typically, the higher the rating, the safer the issue is. Since the Government of India is the primary (or sole) shareholder in these entities, the risk of default is minimal. However, default on interest and principal payment is a possibility that investors need to be aware of.
Liquidity risk: Since these bonds are not traded frequently, liquidity can be an issue. If you want to sell in the secondary market, you may have to sell these bonds at a discount. Investors looking for quick short term gains due to a favourable interest rate movement should be aware of this aspect.
Interest Rate risk: If the interest rates rise in the future, the bond prices may fall in the secondary market. Moreover, the bond prices can rise or fall on mere expectation of interest rate revision. Predicting the direction of interest rate movement is not easy. So, it can become a bit complex for retail investors. However, if you hold the bond till its maturity, you will get all interest/coupon payments along with principal (except in the event of default).
Tax treatment of listed bonds
A listed bond held for a period of more than 12 month is considered a long term asset. On sale of listed bond after 12 months, long term capital gains tax is payable at flat 10.3% (including education cess of 3%). There is no indexation benefit available for listed bonds. If sold within 12 months, short term capital gains will be taxed as per investor’s income tax slab. Additionally, in case of tax free bonds, interest paid is tax-free.
Under debt mutual funds, you need to hold the asset for 36 months for your holding to qualified as long term. Long term gains in debt mutual funds are taxed at 20% with indexation. Treatment of short Dividend from debt mutual funds is also taxable at 28.325% (25% dividend distribution tax plus 10% surcharge and 3% education cess). To know more about taxation of capital gains and dividends in mutual funds, please read our post here.
Thus, the tax treatment of listed bonds fares favourable against debt mutual funds if you are planning to hold for less than 3 years. If held for more than 3 years, tax treatment of debt mutual funds is favourable due to indexation benefits.
Please note tax free bonds are not eligible for deduction under Section 80C. This means you will not get any tax benefits (deduction) for investing in such bonds. However, the interest income from these bonds is tax free.
Should you invest in tax-free bonds?
These bonds are quite suited to investors who seek regular income from their investments. Not many investments will give them regular tax-free income of 7.25-7.75% p.a. There is scope of capital gains if interest rates fall further. However, if the interest rates rise, bond prices can fall too. Additionally, liquidity can be an issue in the secondary market (bonds are not traded frequently). Hence, in case of an emergency, you may even be forced to sell these bonds at a discount. So, if you are looking to invest for capital gains, tax free bonds may not be the right instrument. Investors, who choose to invest in such bonds, should be comfortable holding these bonds till maturity.
We have already seen benefits are greater to people falling in the higher tax brackets. For an investor falling in 10% bracket, pre-tax yield is equivalent to only 8.22% (for tax free interest of 7.4% p.a.). At present, any SBI fixed deposit of tenor greater than 1 year offers 8% or more. Hence, it does not make much sense for people in the lowest tax bracket to invest in these bonds as even a fixed deposit can offer similar or higher interest rates.
Additionally, tax treatment of interest on bank fixed deposits and dividend in debt mutual funds fares poorly against tax-free income on these bonds.
Therefore, investors in the higher tax brackets (20% and 30%) who seek regular income and are comfortable holding the bonds till maturity can go for these bonds.
Your investment decisions shall not be driven by tax considerations alone. Therefore, you should not invest in these tax-free bonds just because the interest is tax-free. These investments should in line with your financial goals. As discussed, the interest rate offered will not be as high as in the previous years. However, for people falling in the higher tax brackets and looking for regular income, these bonds present an attractive investment option. For others, other investment options can offer similar or even better returns. These bonds cannot be a tool for long term wealth creation as benefits of compounding won’t apply. Investors need to take cognisance of associated risks, especially liquidity risk, before investing in such bonds.
Deepesh is a fee-only financial planner and Founder, www.PersonalFinancePlan.in