By calculating the pre-tax yield, an investor will be able to know if the tax-free bond is better than a taxable investment.
The falling interest rate scenario coupled with impending defaults in the fixed-income segment of the market has somewhat shaken the confidence of investors. The interest rate of bank fixed deposit is lying low at around 6 per cent and on top of it, the interest earned is taxable. One fixed-income investment that may suit investors especially those in the high-income slab is tax-free bonds. The current yield in some of the tax-free bonds is around 5.5 per cent while a few companies FDs and fixed deposits of small finance banks are providing interest rate of around 8 per cent. The RBI taxable bonds are offering 7.75 per cent per annum for 7 years. Compared to them, how good are tax-free bonds? Let’s find out.
Currently, on many tax-free bonds, the yield is around 5. 5 per cent. So, is tax-free bond with 5.5 per cent yield better than 8 per cent taxable bond or investment. “Tax-free bond is definitely better because, as per the taxation guidelines, the income after taxation from the 7.75 taxable bonds will be lesser than income from the tax-free bond with a 5.5 per cent yield,” says Sousthav Chakrabarty, CEO, and Director, Capital Quotient. This is true for those paying 31.2 per cent tax than who is paying tax in the lower or middle tax rate.
What are tax-free bonds
Tax-free bonds are similar to fixed deposit or other debentures issued by companies but with certain unique features. As the name suggests, the interest earned by the investor is tax-free in the year of receipt. They generally have a face value of Rs 1000 and carry a Coupon Rate of interest (payable half-yearly) and have a fixed maturity date that can be as long as 15-years. For example, HUDCO, a government company may issue 5 % HUDCO 2035 tax-free bonds.
Yield of tax-free bonds
At the time when such bonds are issued the first time, coupon rate matters. But, later on, when listed, do not merely look at the Coupon rate of interest as the price of the bond may be different in the market. When the interest rate is expected to go down, the market price of tax-free bonds rise and are traded above face value usually Rs 1000. There are several other factors including the interest payment dates that determined market price but calculating current yield may help investors knowing the returns if bonds are held till maturity.
Current yield formula: (Coupon payment received / Market price of Bond) * 100
Let’s assume, a 7% ( coupon rate) tax-free bond ( face value Rs 1,000) maturing in 2035 trading at Rs 1,250 in the stock market. The interest payment received will be on the face value i.e. Rs 70 for every bond of Rs 1,000.
So, Current yield = 70 / 1250 = 5.6 per cent.
This means, if held till maturity, the actual return will be around 5.6 per cent after receiving interest payment at 7 per cent.
Tax-free vs taxable investment
Assuming, one invests in a taxable investment at 8 per cent, the post-tax return for someone paying the highest tax rate will be about 5.36 per cent to 5.5 per cent, depending if a surcharge is paid.
Therefore, by calculating the pre-tax yield, an investor will be able to find out if the tax-free bond suits him or is a taxable investment better.
The formula of pre-tax yield is = ROI/(100-TR)*100
What it means, is that for someone paying 31.2 per cent tax, making an investment in 8 per cent product is same as making an investment in a tax-free bond yielding 5.5 per cent!
Why and where to invest
They are mostly issued by PSU or by government companies and hence considered safe as far as principal is concerned. Further, they are listed on stock exchanges thus providing liquidity to investors. “As they are issued by govt. enterprises to raise funds, such as Municipal bonds, they are considered low-risk investment avenues having a fixed rate of return. It helps in preserving the capital as a risk element is zero and capital protection is assured. However, they don’t give returns as high as equity investments,” says Chakrabarty.
Below are a few tax-free bonds on NSE:
What to do
Taking risk-return into perspective, the investor can, therefore, make the decision easily. If there are taxable investments providing a higher return than 8 per cent with equal or some safety then they may be considered else sticking with tax-free bonds may be better. However, maturity is typically long in tax-free bonds and those with lesser maturity may be available at a lower yield. It’s better to track prices, yield and also the interest rate movement in the economy and then decide rather than taking an ad-hoc investing decision.