How to choose tax-free bonds

The current bond offering from Rural Electrification Corporation (REC) has prompted us to revisit the subject of tax-free bonds. Rather than look at whether REC bonds are attractive, our objective here is to show you how to choose tax-free bonds to align your investments with your life goals. We will use the features of the REC bonds to discuss the factors that you need to consider when you invest in tax-free bonds.

Why tax-free bonds?

Your investment portfolio should necessarily have bonds. Retail bond products have fixed cash flows and finite maturity. This means you will know at the time of investment how much interest you will receive every year and when you will get back your initial capital. You should, for instance, invest in a 10-year bond if you need to fund your child’s college tuition fees 10 years hence. And if expected bond returns are lower than your required return, you should invest a proportion of your capital in equity.

In other words, you have to always invest in bonds. The issue is that interest income is taxed at your marginal tax rate. So, if you receive 9 per cent interest on your fixed deposits, your actual post-tax return at 30 per cent tax rate is 6.3 per cent. And this return will only get lower if the government increases the marginal tax rate for high-income earners!

So, what should you do? Your objective is to ensure that most, if not all, of your bond investments earn tax-free interest. This leaves you with two choices at present. You either have to invest in securities that can fetch you exemption under Section 80 of Income-tax Act for Rs 1 lakh every year. Or you have to buy tax-free bonds. And since Section 80 has an upper investment limit, you have to consider tax-free bonds for your bond portfolio.

The question is: Are you investing excess money at your disposal (discretionary wealth) or are you investing to achieve an objective? If it is the latter, you should buy a bond with maturity closest to your investment horizon. Suppose your daughter is scheduled to enter college 11 years hence, you should buy the 10-year tax-free bond, even if the 15-year bond is attractive!

But what if your investment horizon is 20 years or you are investing your discretionary wealth? You should use the break-even rule. That is, to make a meaningful comparison between, say, the 15-year and the 20-year bond, you will have to assume that all cash flows from the 15-year bond will be reinvested for additional 5 years. The rule is : Invest in the 15-year bond if the break-even rate appears lower than the expected 5-year deposit rate 15 years from now; break-even rate is the rate which makes you indifferent between investing in the 20-year bond, and buying the 15-year bond and reinvesting the proceeds in a 5-year bond.

break-even rule

Based on the break-even rule, the 15-year REC tax-free bond appears attractive compared to the 20-year bond, if you expect the 5-year rate 15 years from now to be more than 5.9 per cent post-tax or 8.5 per cent pre-tax (at 30 per cent marginal tax rate). But the 20-year bond becomes attractive if you expect the tax rate to increase!

You do not have to forecast interest rates to apply the break-even rule. You have to intuitively sense whether the rate in the future will be higher or lower based on the current rate levels. The break-even rule helps you to choose bonds systematically. Importantly, the rule forces you to consider reinvestment risk instead of simply buying a bond that offers you higher interest rate today. You can use the break-even rule for your investments in bank fixed deposits as well.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to >knowledge@thehindu.co.in )

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