Minimise Re-investment Risk through Tax-Free Bonds: Sector Observers

Tax-free bonds are set for a comeback in the next few months, with the government giving a nod to state-owned Indian Railway Finance Corporation and National Highways Authority of India to sell these.

Since the returns of these bonds will be linked to the yield on government securities (G-secs), they are likely to fetch 7-7.25 per cent per annum, lower than the 8.5-9 per cent these offered in 2013-14. Sector observers believe there is likely to be less appetite for such bonds this time from high net worth individuals (HNIs), because of other attractive investment opportunities in equities and long-term bond funds.

Despite lower rates, experts feel these bonds make sense for those in the highest tax bracket. “We are in a declining interest rate scenario and it makes sense to lock-in at these rates for a tenure of 10-20 years. These are ideal instruments for HNIs because of the tax efficiency they offer,” says Ajay Manglunia, head of fixed-income markets at Edelweiss Financial Services.

Beside the coupon rate, investors will also benefit from capital gains if interest rates move south during the next few years. Yields on 10-year government bonds have fallen about 100 basis points, to 7.8 per cent from 8.85 per cent, in the past one year.

At an interest rate of 7-7.25 per cent, the effective pre-tax return for a person in the highest tax bracket works out to be 10.5-11 per cent. “There is no one in the market right now who would pay that kind of a return on AAA-rated paper,” says Dwijendra Srivastava, chief investment officer (CIO), debt, Sundaram MF.

These rates are much higher than post-tax yields from bank fixed deposits (FDs). For instance, the effective post-tax yield for a typical bank FD of one to three years, paying 8.5 per cent per annum, works out to be 5.5 per cent.

There are, however, competing investment options HNIs can look at – fixed maturity plans (FMPs) offered by mutual funds (MFs) and preference shares issued by companies. Investors with a shorter investment horizon can look at three-year FMPs, which offer an indexation benefit and a post tax yield of 7.6-8 per cent. “The returns will be higher than tax-free bonds but if interest rates decline in the coming months, returns in a tax-free bond will be comparable to or better than the debt MF returns, owing to capital gains,” says Umang Papneja, CIO, IIFL Wealth Management.

Preference shares, on the other hand, can be a good choice for investors with a longer time horizon, say experts. Dividend from preference shares are paid annually but the issue size is typically limited to Rs 500-1,500 crore. “Tax-free bonds offer better liquidity than preference shares, and are more tax-efficient when compared to debt MFs if the investment horizon is less than three years,” says Papneja.

The coupon or interest on tax-free bonds is typically paid annually and tax-free. Capital gains on units held for less than a year are added to your income, while gains on units held for more than 12 months are taxed at 10 per cent, or 20 per cent with indexation, whichever is lower.

10-20% bracket

Tax-free bonds might not be ideal for those in the 10-20 per cent tax bracket, say experts. “Someone in the 20 per cent bracket will get about 8.75 per cent taxable equivalent yield, which does not offer a significant spread over a bond or FD available in that tenor with rates of 8.3-8.75 per cent,” says Srivastava.

FDs could make more sense to investors in the 10 per cent tax bracket. For example, the post tax return on an FD offering 8.5 per cent will be around 7.65 per cent for these investors, higher than the yield on tax-free bonds. “Those in the 20 per cent tax bracket can look at five-year tax-free FDs, which can give returns of 8-8.5 per cent, with effective yield working out to about 10.46 per cent, as they are compounded quarterly,” says Srivastava.

However, premature withdrawal in FDs might mean paying a penalty or having to settle for lower interest rates. On Thursday, the Reserve Bank of India allowed banks to offer differential interest rates for deposits above Rs 15 lakh. The rates on premature withdrawal deposits are likely to be lower than normal rates. Tax-free bonds are fairly liquid, as the units are listed on the exchanges.

Besides FDs, those in the 10-20 per cent tax brackets can look at non-convertible debentures, which can fetch post tax returns of anywhere between 7.1 and 8.5 per cent.

According to Manglunia, investors in the 10 and 20 per cent tax bracket can still invest into tax-free bonds, provided they participate for capital gains over the next 12 to 18 months, and not for holding till maturity. Manglunia expects interest rates to decline by 40-50 basis points during the same period, resulting in capital gains of four to five per cent.

There could be another advantage for these investors. Retail applicants investing below Rs 10 lakh in tax-free bonds in the previous issues were offered a 55 bps lesser yield over the G-sec, while HNIs were given a 80 basis points lesser yield. A similar concession might be given for upcoming issues. This means if a 15-year G-sec is quoting at 7.9 per cent, HNIs will get the bonds at 7.1 per cent, while retail investors will get it at 7.35 per cent, resulting in higher capital gains.