1. Investment tip :Tax free bonds of PSUs provide retail investors a safe option

Investment tip :Tax free bonds of PSUs provide retail investors a safe option

Tax-free bonds issued by public sector firms provide retail investors a safe and lucrative option.

By: | Updated: July 14, 2015 3:04 PM
Indian rupee

Tax-free bonds will be issued by seven top public sector companies, including the National Highways Authority of India, Housing and Urban Development Corporation and Indian Railways Finance Corporation, to raise Rs 40,000 crore this financial year.

At a time when banks are cutting deposit rates, retail investors can look at tax-free bonds, which will hit the markets soon, for higher returns. These bonds will be issued by seven top public sector companies, including the National Highways Authority of India, Housing and Urban Development Corporation and Indian Railways Finance Corporation, to raise Rs 40,000 crore this financial year. A retail investor can earn 7.3-7.5% by subscribing to these bonds with 10-, 15- or 20-year maturities.

Tax-free bonds of PSUs are an ideal instrument for risk-averse retail investors. Under these bonds, while the investor doesn’t get any exemption under Section 80C of the Income-Tax Act, 1961, the interest accrued is completely tax-free under Section 10(15)(iv)(h). It is mandatory for the subscribers to furnish their Permanent Account Number to the bond issuer.

Retail investors, comprising individual investors, Hindu Undivided Family (through karta) and non-resident Indians, can invest up to R10 lakh in each issue. An individual can invest in more than one company and still be in the retail category. Individual investors putting in more than R10 lakh are classified as high networth individuals. About 40% of a public issue is earmarked for retail individual investors. Not having to pay tax on the interest earned on such bonds makes them more attractive than other taxable debt instruments like bank FDs.

There is a ceiling on the coupon rates, which is based on government security rates for equivalent maturity. A triple-A rated issuer can sell bonds to retail investors at a rate that is 55 basis points lower than similar maturity government bond yields and 80 basis points lower in case of other investor segments. Any AA-plus rated state-owned company can offer an additional 10 bps above the ceiling rate for AAA-rated entities and any AA or AA-negative rated entity can sell bonds paying an additional 20 bps above the ceiling rate for AAA-rated companies.

Only public sector companies can issue such tax-free bonds, the proceeds of  which are invested in infrastructure projects. Retail individual investors, qualified institutional buyers, corporates and high networth investors can invest in tax-free bonds in varying proportions. In 2013-14, R49,200 crore worth of tax-free bonds were sold, offering yields in the range 8.75-9%. National Housing Bank offered the highest rate of 9.01% for a 20-year tax-free bond, while others like PFC and Hudco offered interest rates between 8.5% and 9%.

Analysts say tax-free bonds are an attractive long-term investment and the volatility in equity markets will further draw retail investors towards them. There is no deduction of tax at source from the interest that accrues to bondholders, irrespective of the interest amount or status of the investor.

These bonds score over bank fixed deposits on account of tax exemption on the interest earned. While post-tax returns on bank fixed deposit range between 6.5% and 7%, tax-free bonds will give an annual return of 9%. However, bank fixed deposits are more liquid than tax-free bonds as the latter have a longer maturity period and are not easy to sell in the secondary market. But again, tax-free bonds issued by companies are backed by the government and, so, the credit risk or risk of non-repayment is very low. Interest on these bonds is paid annually and credited directly to the bank account of the investor. The annual interest payout is good option, especially for those who are want regular income post-retirement.

Financial planners say long-duration bonds reduce the re-investment risk and as interest rates may come down in the long term, it is better to lock in money in tax-free bonds. For investors in the higher tax bracket, tax-free bonds are an attractive option. As bond prices and interest rates move in the opposite direction — when yields fall, prices rise and vice versa — if interest rates fall by 100 bps, investors could also expect a capital appreciation of 5-7%. They can even book profits by selling these bonds, but will have to pay short-term capital gains tax.

What, Why and Who:

WHO CAN ISSUE SUCH BONDS
* Only public sector companies can issue tax-free bonds
WHERE DO THE PROCEEDS GO
* The proceeds from the tax-free bonds are invested in infrastructure projects
OPPORTUNITIES FOR RETAIL INVESTORS
*  About 40% of a public issue is earmarked for retail individual investors
* Retail investors, comprising individual investors, Hindu Undivided Family and non-resident Indians, can invest up to Rs 10 lakh in each issue
* An individual can invest in more than one company and still be in the retail category
* Individual investors putting in more than R10 lakh are classified as high networth individuals
WHAT ARE THE ADVANTAGES
* Tax-free bonds are an attractive long-term investment; the volatility in equity markets will further draw retail investors towards them
* There is no deduction of tax at source from the interest that accrues to bondholders, irrespective of the interest amount or status of investor
TAX-FREE BONDS VS BANK FDs
* Tax-free bonds score over bank fixed deposits on account of tax exemption on the interest earned
* While post-tax returns on bank fixed deposit range between 6.5% and 7%, tax-free bonds give an annual return of 9%
* Bank fixed deposits are more liquid than tax-free bonds as the latter have a longer maturity period and are not easy to sell in the secondary market
* Tax-free bonds issued by companies are backed by the government and, so, the credit risk or the risk of
non-repayment is very low

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