Good news for
investors.
Tax-free bonds worth `40,000 crore could be issued in this finan cial year. The interest earned on these bonds is tax-free and is paid out annually. The bonds come with tenures of 10, 15 and 20 years. The coupon rate is linked to the current yield of a government security with a similar tenure. The ceiling coupon rate for
AAA-rated issuers of these bonds would be fixed at 55 bps below the government bond yield for retail investors and 80 bps for other investors. Investors who put in up to `10 lakh are classified as retail investors and get a higher coupon rate. Individuals investing more than `10 lakh are classified as
HNIs. At current yields, investors are likely to get between 7.3%-7.7% for various tenures of tax-free bonds.This is equivalent to a
pre-tax return of 10.56%11.14% for someone in the 30% bracket.
Are these bonds safe?
As these are mostly AAA-rated bonds, the safety of capital is not in question. In a declining interest rate scenario, these bonds would also provide decent capital appreciation. Even though interest income is tax free, if you sell tax-free bonds before maturity, the capital gains is taxed. Unlike debt funds, which must be held for at least three years if the investor wants his gains to be classified as long-term capital gains, tax-free bonds are eligible for long-term capital gains after a year.
Invest for retirement income
For those nearing retirement or already retired, these instruments are a great platform for generating regular income. A guaranteed tax free return of around 7.5% for the next 10-15 years is a fantastic proposition. It is good for those who do not need the money back for a long time and are risk-averse. The predictable return and tax-efficiency make these an ideal option for post-retirement income. Annuities offer low yields and are tax inefficient.
While the interest payout is once a year, one can spread the flow of income by investing in several bonds. Tax-free bonds can be used to generate a post-tax cash flow, by not only diversifying the payment of coupon but also the issuer of the instrument. Calculate how much you would need per month and then spread out your investments across different bonds accordingly. Suppose you need `15,000 per month, or `1.8 lakh every year. To generate this, you need to invest about `24 lakh in tax-free bonds, assuming a coupon of 7.7% on a 20-year bond.To qualify for the higher coupon, the investment in each issue should be less than `10 lakh. In this case, you can spread the outlay across four issues for `6 lakh each.Invest in bonds in such a way that the interest in paid in different quarters. This will provide you a steady income all year. Though your capital is locked up for the duration of the bond, you can exit by selling in the secondary market.
Replace tax-inefficient FDs
If you are an avid investor in Bank FDs, use the forthcoming tax-free bonds issues to make your portfolio more tax-efficient. The interest earned on FDs is taxed at the normal rate corresponding to your slab. The 8.5% pre-tax return of an FD may seem more attractive than the 7.37.7% offered by the tax-free bonds.But the post-tax yield of the bonds is certainly higher, especially for those in the highest 30% tax bracket (see table). The coming bond issue provides a lucrative opportunity to lock-in to high yields for a long time in a more tax-efficient avenue. An FD will only make sense for someone in the 10% tax bracket, as the effective post tax yield of 7.65% works out better or equivalent to the expected coupon on the upcoming bonds.
Even the existing tax-free bonds are offering better yields than FDs.Though bond prices have surged in the past year, the yield-to-maturity of most bonds is still above 7%. The only advantage of bank FDs is that they are more liquid.
Are there better alternatives?
However, there are other options in the debt segment that should not be ignored by investors. The PPF remains the best option for those who do not wish to redeem the money for a very long time. Not only is the higher interest payout of 8.7% completely tax-free, but the principal up to `1.5 lakh is eligible for tax deduction under Section 80C. However, unlike the tax-free bonds, the interest rate on PPF is market-linked, so can be expected to come down in a declining interest rate scenario.
Debt mutual funds also have the potential to provide a higher yield while also providing high tax benefits. These can fetch 8-9% over the long term, with negligible tax incidence after indexation. If you sell these after 3 years, any gains are adjusted downwards for inflation and taxed at 20%. The liquidity on these funds is also significantly higher than tax-free bonds. If you set up an systematic withdrawal plan from these funds after 3 years, these can also provide a regular income. However, returns on these funds are not guaranteed.
Invest for capital gains
For those who don't intend to hold on to tax-free bonds till maturity, these offer an opportunity to make healthy capital gains on invested amount. To be able to sell these in the secondary market, you need to invest in the dematerialised form.These instruments are listed on the exchanges, where you can sell them at any time. If interest rates decline, the value of these bonds will go up. Most of the existing taxfree bonds issued in 2013 and 2014 have churned out terrific returns.For instance, the 20-year tax-free bond from National Housing Bank (NHB), which hit the market on 30 December 2013, is quoting at `6,090, a return of 21.8% on issue price of `5,000. This is not including the tax-free interest that has already been paid till now.
The reasons for such capital appreciation are manifold: First, there was no fresh supply of taxfree bonds last year. The limited supply in a reducing interest rate environment stoked the demand for existing papers. Second, the Budget revised the tax rules for debt mutual funds last year, increasing the tenure for the applicability of long-term capital gains tax on them from one to three years.This drove HNIs to tax-free bonds, which continue to enjoy long term capital gains benefit after one year.Lastly, the fall in inflation prompted rate cuts by RBI which pushed up bond prices. But can investors expect similar capital appreciation in any of the upcoming bonds?
Yields on the 10-year bnechmark government bonds have fallen about 92 bps to 7.82% over the past year. Although the RBI didn't tinker with policy rates in the recent monetary review, there is anticipation of further interest rate cuts over the next year or two. With CPI falling within the RBI's target range, we believe that there could be around 50 bps reduction in policy rates in the second half of the fiscal. So, the possibility of capital gains in these instruments is still high, and similar gains could be on the cards.
Invest in name of spouse
While the tax angle is a reason to invest in tax-free bonds, you can derive additional tax benefits if your spouse is in a lower tax bracket or does not have taxable income. By investing in the name of your wife, the clubbing provisions of the Income Tax Act will kick in.While the income from the investment is treated as your income, any income from the reinvested income is treated as your wife's income and taxed in her hands.Since clubbing of income happens only at the first level, you can squeeze a tax arbitrage by investing in her name. Here's how you can make this rule work for you: Gift money to your spouse and then get her to invest in these taxfree bonds. The interest will be added to your income, but since it is tax-free anyway, there won't be an additional liability for you. Also, the money gifted to your spouse will not be taxed in her hands. Your wife can then reinvest the earned income elsewhere. This time the income will not be clubbed with yours, but your wife's. This strategy works only if your spouse is in a lower income bracket or does not have taxable income. But this strategy will not work in the case of minor children
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