Should you invest in Tax-Free Bonds?

“Ohh Man! I did my tax saving investments 2 months back only. Otherwise I would have invested in these tax-free bonds. But now I can’t invest in them.” said Mahesh Kuntal, a 34 year old executive, working with a leading pharma company. He was having a casual discussion in tea-time with his colleague Kapil.

Kapil: What does tax saving investments have to do with this?

Mahesh: We can only invest Rs. 1 Lakh in tax-free right?

Kapil (smiling): I think this is the most common problems with most of us. We call ourselves educated but we hardly have financial literacy. Let me clear few things here:

1. Tax Saving Investments and Tax-free investments are entirely different from each other.

2. In tax saving investment, you get a deduction on the amount invested. Let's say, if you invest Rs. 1 Lakh in any of PF, PPF, ELSS, Insurance Premium, NSC, Tax Saving Bank FD etc, you would get a tax deduction upto Rs. 1 Lakh u/s 80C. But that does not mean that the returns would also be tax free. For example, the interest earned on Tax Saving Bank FD and NSC are taxable.

3. In Tax Free Investment, you don’t get a deduction on the investment made. However, the returns generated are tax free. i.e. they are not clubbed with your taxable income.

4. There is a limit of Rs. 1 Lakh for investment in tax saving products. However, there is no limit on investments in tax-free products.

Mahesh: I am understanding to some extent. But I have few more queries. If I don’t get a tax deduction, does it make sense to invest in a tax-free investment?

Kapil: Well, it will depend on your tax slab. Let's say, you are in a 10% tax slab, you would get a 9.25% interest rate in a Bank FD (Pre-tax). The post-tax returns would be around 8.3%. Thus, it would be better to invest in a tax-free bond giving a yield higher than 8.3%. Currently you are getting around 8.5-8.6% on tax free bonds.

Likewise if you are in a 20% tax slab, then even if a Bank FD pays you 9.5% (pre-tax), your post tax returns will be 7.54% only. Thus, any tax free bond giving you returns higher than that would be beneficial for you.

And in case you are in a 30% tax slab, even a bank FD paying you 10.5-11% returns (pre-tax), your post tax returns will be 7.6% only. Again, a tax free bond will score over it.

Only if you are in a NIL tax slab, you may go for a bank FD or a taxable interest instrument as tax-free bond won't be much beneficial for you.

Mahesh: O Wow! Never thought it that ways !! So now I am in 20% tax slab, and tax free bonds are giving yields closer to 8.6% these days. So they would definitely be a better choice than Bank FD. But I have one more query. How do these tax-free bonds compare with PPF?

Kapil: Good Question! Since you are a Football Fan, I will explain you this way. PPF loses the match with Tax-free bonds by 1-4.

Mahesh: Sounds interesting! Please elaborate.

Kapil: Sure. PPF scores over Tax free bonds in only one aspect i.e. investments made in PPF would qualify under Sec 80C and investments made in tax-free bonds won't qualify. However, Tax – Free Bonds score over PPF in 4 parameters:

No Limit on investment: Suppose you have Rs. 10 Lakhs to invest. You can't invest them in PPF. But you can invest them in tax-free Bonds.

Better Liquidity: Since the tax-free bonds are listed, you can liquidate them anytime. Whereas for PPF, you have lot of restrictions for liquidity.

Opportunity of Capital Gains: If in future, there is a fall in interest rates (which is quite likely), you have an opportunity of earning capital gains from tax-free bonds. Let's say there is a fall of 1% in interest rates in the next one year, then you can expect a capital gain of 13-14% in a tax free bond. This capital gain would be in addition to the tax-free interest offered. This means you have an opportunity to earn a return of 21-22% from a debt instrument through tax free bonds.

Fixed returns: As we know that PPF interest rates are linked to 10 Year G Sec yield, there is a chance that we may get less returns from PPF in future. Lets say if the Gsec Yield falls, then in future you might get only 6.5-7% interest on PPF. However, in case of tax free bonds, the interest being paid will be fixed i.e. if you buy a tax-free bond paying 8.6%, it will keep paying you 8.6% for the next 15 years (tenure of the bond). Also, On the contrary, fall in 10 year G Sec yield will earn us better returns in Tax-Free Bonds in the form of capital gains explained above.

Mahesh (happily): So all in all, tax free bonds score over several investment avenues. Especially people who are having taxable income. And in my case, I am already done with my tax saving investments. So this would in effect work like a tax saving investment for me, as I do not need to pay tax on the interest earned. Thank you so much for sharing all this info, Kapil.

I will see that I break my FDs which are earning 8-9% taxable and invest in tax free bonds to earn 8-9% tax free. Even if I move Rs. 5 Lakhs from my taxable FDs to Tax Free Bonds, I will be able to save Rs. 5,300 every year for the next 15 years i.e. saving of Rs. 79,500 in the next 15 years. Plus, if I want to sell these bonds, I can make capital gains too. Thanks again!

We look forward to your feedback and comments on the above article.

The Author Prof. Saurabh Bajaj (BE, MBA, FRM) is Chief Investment Planner with Nidhi Investments. He may be contacted us on saurabh@nidhiinvestments.com if you have any questions. (The views mentioned in the article are personal opinion of the author)