Forget fixed deposits: Tax-free bonds in secondary markets fetch higher returns

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Updated: May 17, 2016 10:42:29 AM

Tax-free bonds sold in the secondary markets can fetch higher returns than fixed deposits of banks and companies

RupeeThese bonds can now be bought from the secondary market and can earn up to 3% more than bank fixed deposits after tax. (PTI Photo)

At a time when banks are reducing interest rates on fixed deposits, smart investors are picking up tax-free bonds from the secondary market to earn higher returns. These bonds, which were floated by various state-owned companies in the last few years, can now be bought from the secondary market and can earn up to 3% more than bank fixed deposits after tax.

Tax-free bonds are an ideal instrument for risk-averse retail investors. Tax-free bonds are liquid and are issued by government-backed companies, and have high credit ratings. However, this financial year, there will be no fresh issue of tax-free bonds. An investor can purchase tax-free bonds issued in the last few years from the secondary market and hold it for a long period. 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).

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.

So, if an investor who has parked money in State Bank of India’s 10-year fixed deposit, which is offering 7% interest, and if he is in the highest (30.9%) tax bracket, the effective rate goes down to around 5%. The recent issues of National Highways Authority of India (NHAI) have yields of 7% returns and investors do not have to pay any tax on the returns.

Retail investors, comprising individual investors, Hindu Undivided Families (through karta) and non-resident Indians can invest. Not having to pay tax on the interest earned on such bonds makes them more attractive than other taxable debt instruments, like bank FDs.

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

Before investing in tax-free bonds, one must look at the issue size as it may impact liquidity. For instance, NHAI’s R10,000-crore bond issue has the highest traded volume on bourses. One must also look at the credit rating of the issuer and the tenure of the bond. Experts say long-duration bonds reduce re-investment risk and, as interest rates may come down in the long term, it’s better to lock in money in tax-free bonds. For those in the higher tax bracket, tax-free bonds are an attractive option. Bond prices and interest rates move in the opposite direction — when yields fall, prices rise and vice versa.

Company fixed deposits

Even company fixed deposits of top-rated firms are much in demand as they pay 50-150 basis points more than bank fixed deposits and are ideal for an investment horizon of one-three years. However, investors must exercise utmost caution and take an informed decision because, unlike bank deposits, a company can default on payment of interest and principal. Bank deposits provide security of up to an investment of R1 lakh, which is not the case with corporate fixed deposits.

Analysts say investors should not put in money in a single company fixed deposit and and instead, diversify in four to five companies. Also, investors must avoid investing in those companies that mention very high interest rates and whose balance sheets show losses. If one invests in a company that is low on ratings, go for a short tenure, which will enable you to opt out if the company is not performing well. However, in case of a long-term investment, the investor will be stuck with the company if it defaults or goes bankrupt.

Company deposits pay interest at monthly, quarterly or yearly intervals and income tax is deducted at source if the interest paid is over R5,000 in a financial year. For bank deposits, TDS is only deducted if the interest income is over R10,000 a year. Senior citizens — those who have completed 60 years on the date of deposit/renewal — get an additional interest rate of 0.25% per annum. The tenure of company deposits ranges from one to seven years and one can earn compounding interest by reinvesting the principal amount along with the interest earned. Investors can get direct ECS credit facility for interest payments or advance interest warrants for the year. However, unless one needs income regularly, they should prefer cumulative schemes to regular income options since the interest earned gets reinvested at the same coupon rate, resulting in better yields.

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