Tax free bonds merit serious consideration

I had written this post on Should you invest in NTPC Tax free bonds at the time the issue came out. As all of you know the NTPC issue as well as the earlier PFC one had been oversubscribed greatly. There are, of course, several other Tax free bonds in the offing, the largest of these will probably be the NHPC one. In the lower interest rate regime unfolding before us, will it be a good idea to revisit investing in these bonds?

Before getting into the 2015 series, let us look at a little history on what happened the last time these bonds were issued. In 2013 there was a slew of such issues and the interest rates then were around 8.8 % for retail investors buying the 15 year tenure bonds. As I have written in other posts, I subscribed a reasonable amount in these bonds, mainly because I wanted a source of passive income as the plan was to give up my regular job by 2014 end. Now, the three main objections that people had against these bonds were as follows – interest rates can increase and you’ll be stuck at 8.8 %, these bonds have no real liquidity and after 15 years the principal will hardly have any value.

Now that the bonds are about 2 years old, let us see whether these objections were relevant or not. The interest rates are going down and even the best rates available for FD today in in the range of 7.5 %, which is of course taxable. What about liquidity? Contrary to what most people thought, these bonds are actually selling in the secondary market at a price appreciation of 10-20 % in 2 years. What is more, you only have to pay 10 % tax on your capital gains if you sell these after one year. As far as the value of principal after maturity goes, that will be true of any debt instrument. So, as far as I am concerned, I feel quite justified in having made the investments in 2013.

Let us now come back to the point whether you should be investing in these as part of your debt portfolio. I have reproduced below a chart from the Economic Times that compares the various options in this space.

Why forthcoming tax-free bonds may be a good bet

You will see from here that these bonds score highly against most other options. Yes, if you are able to invest in actively managed debt funds and track your investments here closely, you may get higher returns as compared to tax free bonds of today. However, keep in mind that with inflation coming down, the cost inflation index will also slow down and this will mean a higher LTCG to be paid when you redeem these debt funds.

I am a strong believer that we have entered into an era of lower interest rates and instead of the earlier mean of around 9 % we will probably settle down at the present 7.5 % or so. In fact, over the next year or so, I will not be surprised if the interest rates actually reduce to 6.5 % or so. In such a scenario it does make sense to lock in the rates at these levels.

Obviously, not everyone should invest in these bonds. Young people who are into building their equity portfolio, should ideally have only PF and PPF as their debt component in their portfolios. However, people looking to set up a passive income, people in retirement, people whose portfolios are laden with tax-inefficient FD must look at these bonds as a good option for investment.

I am perfectly happy with the earlier edition of these bonds and I am sure a lot of you will be thinking the same after 2 years if you invest in this edition. Obviously, a lot of people already think so and this is demonstrated in the investor response to both the PFC and NTPC bonds.

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3 thoughts on “Tax free bonds merit serious consideration

  1. Capital Gains tax after one year? There seems to be some mistake here. The prospectus of NTPC Bonds quotes inter alia, Sec 2(42A) of Income Tax Act which stipulates 36 months limit to qualify as LTCG – 12 months being limited to shares & E.O.MF units.

    May be it’ll get corrected in the next issue.

    S.K

    Like

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