Tax-free bonds: Not just a tax shelter

Written by Saikat Neogi | Updated: Oct 4 2013, 23:29pm hrs
InvestorsFor investors in the highest tax bracket, the effective yield is high. (IE Photo)
Tax-free bonds launched by public sector companies are an ideal instrument for risk-averse retail investors. After Rural Electrification Corporation and Hudco, state-owned India Infrastructure Finance Company (IIFCL) has now launched a public issue of tax-free bonds to raise Rs 2,500 crore, with tenures of 10, 15 and 20 years. The issue will be open for subscription till October 31.

Under tax-free bonds, while the investor does not get any tax exemption under Section 80C of the Income Tax Act, 1961, the interest accrued is completely tax-free under Section 10(15)(iv)(h).

Only public sector companies can issue such tax bonds. Retail individual investors, qualified institutional buyers, corporates and high net-worth investors can invest in the tax-free bonds in varying proportions. Investors applying for an amount aggregating up to R10 lakh across all series of bonds in each tranche issue will come under the retail individual investor category. The same retail investor can also apply again in the next tranche or in the issue by other companies tax-free bonds.

Earlier this financial year, REC mobilised R3,500 crore through such bonds. Hudco, whose tax-free bond offering is currently open for subscription, is looking to garner R4,809 crore.

In its red herring prospectus, IIFCL had said that it plans to raise R8,171 crore through tax-free secured, redeemable, non-convertible bonds of the face value of R1,000 each for the current financial year. The company has now decided to restrict the issue size to R2,500 crore in the first tranche.

For retail investors, IIFCL, in the first tranche of the bond, is offering rates of 8.26% for 10-year paper, 8.63% for 15-year paper and 8.75% for 20-year paper. So, it makes sense for you to lock-in your money for a long period as this is not only the highest possible rate but also the interest accrued is completely tax-free.

For investors in the highest tax bracket, the effective yield is high. However, for qualified institutional investors, corporate and high networth investors, the rates are marginally lower 8.01% for 10-year bond, 8.38% for 15-year bond and 8.50% for 20-year bond. 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 with the high rates that these tax-free bonds offer.

Icra has assigned a credit rating of AAA to the IIFCL bonds. Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Similarly, Brickwork Rating has assigned a credit rating of AAA; Credit Analysis & Research has given a credit rating of AAA to the bonds.

Non-convertible debentures

For retail investors, some non-banking finance companies are launching non-convertible debentures (NCDs) with higher interest rates. However, financial planners say higher rates should not be the only reason to lap up NCDs.

Instead, before investing, investors must look at the company's past lending performance, cash flows and business risk to ensure that it does not default on payments after maturity. Financial planners also say that while it is always prudent to allocate some part of ones portfolio to NCDs, the investment should not be over 20% of the total portfolio because of the risk involved. Also, NCDs are not as liquid as bank fixed deposits as the secondary market for corporate bond is not that well developed. Without a vibrant secondary market for these bonds, an investor may have to sell the NCDs at a discount and NCDs can never be converted into equity or preference shares. After maturity or redemption, the company gets back its debenture and the debenture holder gets back the principal invested, along with the interest accrued.

NCDs can be both secured and non-secured. All secured NCDs are backed by assets and if the company defaults, the secured assets are then liquidated to repay NCD investors. With unsecured NCDs, companies offer a much higher rate as there are no assets that can be liquidated in case of default. If NCDs are sold on the stock exchange within 12 months of the date of allotment, an investor will have to pay short-term capital gains tax. Beyond one year, it will be treated as long-term gain.