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Wednesday, December 01, 2021

Creating wealth through tax-free bonds

If you have an investment amount that you will not need over the next 10 years or so,it makes good sense to invest in tax-free bonds

December 9, 2013 1:23:46 am

BR Raghunandan,62,who retired as the executive director and company secretary at Rural Electrification Corporation (REC) in April 2011,on Thursday pulled out his retirement corpus amounting to Rs 40 lakh from his Employee Provident Fund account and has invested Rs 10 lakh each in tax-free bonds of NTPC and HUDCO in his and his wife’s name for a period of 10 years.

With decent savings,fixed deposits in banks,a house in Noida,well-settled kids and no liabilities,all that the Raghunandans were looking for was a constant stream of income at a rate that can meet their monthly expenditure. Tax-free bonds offering interest of up to 9.01 per cent came just at the right time for the couple.

“I would not have earned interest on the money in my EPF account beyond three years of retirement and had thought to invest it in fixed deposits. However,tax-free bonds came at the right time offering me high tax-free interest income every year,” said Raghunandan,who will start earning annual interest on his bonds beginning December 2014.

“I plan to use the annual interest income from the bond judiciously in a manner that I could meet my monthly household expenses over the next one year,till the next interest income is due,” he said.

Raghunandan is one of the thousands of investors who have broken their fixed deposits,pulled out money from their public provident fund (PPF) and even from EPF in order to invest in the tax-free bonds that are available in the market for subscription and offering an annual interest of up to 9 per cent. The phenomenon may also throw some light on the rush to subscribe to these bonds.

“If an investors does not need the money for the next 10 years,it is a no-brainer to invest in these bonds. However these bonds offering high tax-free interest rates are more lucrative than fixed deposits and even PPF and therefore we have seen a lot of investors breaking FDs and pulling money out of their PPF accounts and investing in these bonds,” said Rajiv Deep Bajaj vice-chairman and managing director,Bajaj Capital.

While public provident fund is currently offering 8.7 per cent,the investment amount is capped at Rs 1 lakh per individual in a year and also it does not offer annual interest income.

What are these bonds?

These are bonds issued by public sector undertakings and the interest offered on the bonds attract no tax thereby making them attractive. The bonds are benchmarked to the GSec yields and since the yields had hit to levels of around 9 per cent in the recent past,the bonds being offered by the PSU’s at this time have are carrying a high coupon interest rate. The bonds offer annual interest and are also listed on the stock exchanges where they can be traded and therefore investors can make capital gains on the bonds when the yield on GSec falls as they can sell their bonds at a premium in the market.

Raghunandan,however,says that he will not be trading his bonds in the market and is looking for stable regular income rather than capital gains from it.

NTPC,HUDCO and IIFCL have announced their tax-free bonds offering a minimum of 8.66 per cent interest and a maximum of 9.01 per cent to the retail investors. NTPC’s AAA rated bond that was offering 8.66 per cent,8.73 and 8.91 per cent to the retail investors on bond tenures of 10,15 and 20 years respectively came to a close on Thursday even though it was planned to close for subscription on December 16,as the issue witnessed a 3.3 times subscription to its Rs 1,000 crore bond issuance (that has an option to retain oversubscription amounting to Rs 750 crore).

However,HUDCO’s ‘AA+’ bond is offering up to 9.01 per cent will remain open for subscription till January 10. IIFCL’s ‘AAA’ rated bond issuance that will offer an interest of up to 8.91 per cent will open for subscription on December 9,2013.

Retail investors however can invest only up to Rs 10 lakh in such bond issuances.

Why are they better than Bank FD’s?

A look at the interest rates being offered by the banks shows that they are not too bad. State Bank of India is offering an interest rate of 9 per cent on its term deposit of 1 year and above and the Bank of Baroda is offering a rate of 9.05 per cent on the same.

While the interest rates being offered by banks may seem comparable,the difference comes on the fact that the bonds are tax free,where as the interest income on the term deposits with banks attract tax at the marginal tax rate.

So if your income falls in the highest income tax slab of 30 per cent then it will be taxed at that rate. Therefore a pre-tax equivalent for an investor in the highest tax bracket on a bond offering 8.66 per cent will stand at 12.37 per cent whereas that on 9.01 per cent bond will stand at 12.87 per cent. Such a return on AAA and AA+ rated instruments backed by government is a rarity.

Alternatively,a post-tax return on a 9 per cent FD will be 6.3 per cent (at the 30 per cent marginal tax rate) whereas the bond offers you up to 9.01 per cent tax free. So there is a clear gap in the income generation from the two options.

If you invest Rs 10 lakh in a 9.01 per cent bond (where you reinvest the interest income in an instrument – equity etc–that also grows at the same rate) then in a period of 10 years your capital would grow to Rs 23.69 lakh. However,if the same amount is invested in a FD offering 6.3 per cent post tax then your capital grows to only Rs 18.4 lakh. So the difference in your wealth creation amounts to Rs 5.27 lakh in a period of 10 years on an investment of Rs 10 lakh.

Better than other investment options

Experts in the investment field say that the bonds offering such high rates have thrown up an opportunity for wealth creation which rarely come up and would not be there for long.

“It should not just be looked as an investment option but as a wealth creation tool as it is comparable to a taxable instrument offering up to 13-14 per cent return. These bonds can also generate capital gains along with the interest income,”said Bajaj.

Over the last few years the return on real estate has gone down and even gold has not been able to duplicate the returns it generated between 2005 and 2011. Experts also feel that gold generally hedges against inflation and therefore the long term return generation may remain similar to the inflation.

Why you should take it now?

If you have a surplus or investment amount that you will not need over the next ten years or so then it makes a good case to invest. With GSec yields being volatile and currently trading at levels of 8.7,there may be a possibility that the bonds that come up for subscription later may not carry such high coupon rates unless the GSec yields rise from here. It may therefore make sense to grab the opportunity and invest in the same.

Also,at yields of 7-8 per cent,these bonds used to make sense for only the high net worth individuals to invest but with yields hitting as high as 9 per cent,retail investors should get into it for wealth creation.

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