Should you invest in tax-free bonds? As an investment providing tax-free income, these bonds may fare well when compared to bank fixed deposits and debt mutual funds
Gaurav, a public-sector senior executive, is in his late thirties and looking to invest in a fixed return product with minimal risk to build a retirement corpus. He has heard of a few credit accidents and is vary of default risk. His investment adviser tells him that several tax-free bond issues are coming up from public-sector undertakings, infrastructure companies and municipal corporations. Such bonds have long tenors, typically maturing after 10, 15 or 20 years, and would make for an ideal inclusion in his retirement portfolio. Every year, interest/coupon will be paid to Gaurav and will be tax-free income, while the principal amount will be returned to him on maturity, but it will not offer any tax benefit. These bonds will also be listed on a stock exchange, which would allow investors to benefit from any appreciation in price and exit the bonds before maturity. Gaurav is wondering whether he should invest in any of these taxfree bonds.In order to take a decision to invest in tax-free bonds, Gaurav must weigh its features against other investments. As an investment providing tax-free income, these bonds may fare well when compared to bank fixed deposits and debt mutual funds. However, Gaurav should calculate the effective pre-tax interest rate equivalent and compare it for various options. As an individual in the highest tax bracket, he will enjoy the maximum benefit. A 6% tax-free return would mean approximately 8.5% return for someone in the 30% bracket, and 7.5% in 20% bracket. For anyone who falls in the 10% tax bracket, the benefit will be marginal. Moreover, compared to other corporate bonds, these bonds will be highly rated in terms of credit quality. As government of India undertakings, they offer minimal risk of default.
However, Gaurav must bear in mind the long tenor. If he believes that he will be able to sell it on the stock exchange when interest rates drop, and make handsome capital gains, he must remember that selling such bonds may not be possible for retail investors like himself. These bonds are not traded frequently. He must be open to the possibility that he may be stuck with this investment for its entire term of 10, 15 or 20 years. He must, therefore, ensure that he does not have a short-term goal associated with tax-free bonds.
Gaurav must understand that his investment decisions should not be driven by tax considerations alone. He should not invest in these bonds just because the interest is tax-free. He must follow the primary rule of investing— product choice should be driven by his financial goals. The safety from default risk comes at the cost of liquidity. Tax-free bonds can be attractive for him if he is in the higher tax bracket and has no concerns on funds being locked for longer time horizons.
Content courtesy Centre for Investment Education and Learning (CIEL).
Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
This story originally appeared on: India Times - Author:Faqs of Insurances
