Bank FDs Vs Tax-Free Bonds: Which of the two will give you higher returns?

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Published: August 7, 2019 12:45:31 PM

Bank fixed deposits (FDs) are one of the most favourite savings instruments among Indian investors despite low return and tax inefficiency, resulting into capital erosion over long term.

fixed deposit, FD, bank fixed deposits, Bank FDs, FD interest, inflation, income tax, tax inefficiency, tax-free bonds, tax-free return, coupon rateDue to easy investment process and blind faith on banks, most people remain stuck to FDs.

Bank fixed deposits (FDs) are one of the most favourite savings instruments among Indian investors despite low return and tax inefficiency, resulting into capital erosion due to lower post-tax return than the rate of inflation. Due to easy investment process and blind faith on banks, most people remain stuck to FDs, as they don’t want to opt for other lucrative options due to lack of information about the products and fear of losing capital.

However, apart from FDs, not all financial products are risky market-linked products and may provide either higher returns or tax efficiency or both. Tax-free bonds are such instruments which often give higher tax-free returns with adequate capital protection.

“Tax-free bonds are a compelling investment opportunity for individuals, particularly individuals in the highest tax bracket. In comparison with traditional fixed deposits, tax-free bonds are more tax efficient. Yield on tax free bonds for all practical purposes is the tax-free equivalent rate of return for investors. Unlike fixed deposits, where in investors have to pay tax on interests earned, interest/coupon earned on tax free bonds is tax exempt,” said Devang Kakkad, Head of Research, Equirus Wealth Management.

“Additionally, unlike fixed deposits where in investors incur a levy/penalty for premature withdrawal, tax-free bonds can easily be sold be in the secondary bond market as these bonds are not only listed but also frequently traded. As with any investment opportunity, it is important for investors to consider a holistic asset allocation approach and evaluate their investments in tax-free bonds accordingly,” he further said.

Although, tax-free bonds are traded in secondary markets, but for doing so conveniently, investors need to have demat accounts, which is not required for premature withdrawal of FDs. It is also a reason that most people favour FDs over other instruments.

While the rate of interest on FDs are now hovering around 6-8 per cent, many tax-free bonds that were issued earlier with similar coupon rates and are now available in secondary markets. As FD interests are taxable, even the 8 per cent interest will become 5.6 per cent for an investor, who is in 30 per cent tax bracket without even including the effect of cess. Similarly, for a person in 20 per cent tax bracket, the post-tax rate will come down to 6.4 per cent.

Now take example of REC LTD – 8.12 tax-free bond, which has coupon rate of 8.12 per cent, face value of Rs 1,000 and will mature on 2027. The bond is currently available in secondary markets for Rs 1,128. Even if the rate of interest is calculated on the current market price, the tax-free rate will be 81/1128 or 0.0718 or 7.18 per cent.

So, the rate of return on tax-free bond of the REC Ltd is higher than the post-tax return of FDs with highest interest rate. Compared to FDs, bonds with tax-free rate of return of around 6.5 per cent would be better for the investors.

“In 2018, there were five public sector companies that generated about Rs. 28,000 crore by issuing tax-free bonds. In these tax-free bonds, retail investors have garnered about 12 per cent to 16 per cent returns in the last 8-10 months of their investments,” said Ankit Agarwal, Managing Director, Alankit Limited.

“Have any investor book such returns in FDs?” he questioned.

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