Why tax-free bonds are a good alternative to bank FDs

With interest rates at historic lows today, investors looking for better-return, fixed-income options can consider tax-free bonds available in the secondary market. These bonds can be a relatively low-risk alternative to many bank fixed deposits for those in the higher tax brackets.

Tax-free bonds

Tax-free bonds are issued by public sector undertakings such as NHAI, HUDCO, PFC, REC, IRFC, with maturities of 10 years or longer. The last primary bond issue was in March 2016. You can buy these bonds from the secondary market. They are listed on the BSE and the NSE.

‘Tax-free’ here refers only to the tax-free interest. That is, you don’t have to pay any tax on the interest (coupon) received on these bonds. These bonds are not included under Section 80C (Income Tax Act) investments and the money invested in them is not eligible for deduction from your taxable income. The interest on such bonds (paid out periodically) is tax-exempt while that on fixed deposits is taxed at your income tax slab rate.

Note though that while tax-free bonds from certain issuers may enjoy good trading volumes, if you have large bond holdings (of say a few crores of rupees), you may need a few days to a week to exit your holdings completely. “Monitoring of price (and hence yield) and volume of past 1-2 months is required before investing,” says Deepak Jasani, Head of Retail Research, HDFC securities. Liquidity may, however, be less of a concern for those with smaller investments.

What bonds to choose

Given the current interest rates, further rate cuts don’t appear likely. To avoid missing out on higher returns once the rate cycle starts turning up gradually, you can invest in tax-free bonds (that have good trading volumes) with a residual maturity of around two years that offer the best yield-to-maturity (YTM). Also, it’s best to stick to AAA-rated bonds (a few are rated below AAA) as they come with the highest degree of safety.

Data from HDFC securities show that AAA-rated IIFCL bonds (series -719IIFCL23) priced at ₹1,114 per bond, with a residual maturity of 2.2 years and daily average trading volumes of 2,557, offer a YTM of 4.71 per cent. The YTM shows your return from a bond if you hold it until maturity.

Do note that YTM calculations assume that interest from a bond is getting reinvested at the same current yield. Tax-free bonds make periodic interest payouts to investors. So, depending on the rate at which these are reinvested, your actual return can be lower / higher than the YTM. For a bond with a relatively shorter residual maturity such as two years, this impact may, however, be very small.

If you sell the bond before maturity, your final return will also depend on the selling price versus the purchase price of the bond. This could result in a capital gain or loss for you – which is the interest rate risk.

Risk return trade-off

While tax-free bonds may not carry as low a risk as many bank fixed deposits do, the AAA-rated bonds do offer a good degree of safety. Unlike bonds, fixed deposits carry no interest rate risk – that is, the value of the original investment remains unchanged. Also, while tax-free bonds may not be perfectly liquid (for large holdings), fixed deposits can be liquidated any time, though subject to a penalty in many cases.

That said, tax-free bonds are issued by public sector undertakings that enjoy Government of India backing. So, they carry low risk of default and can be considered safe.

Who should invest

Investors who are not completely risk averse and are in the 30 per cent tax bracket, can invest in the IIFCL tax-free bonds as an alternative to many public and private sector bank, and small finance bank FDs that are offering lower post-tax returns (see table). Those in the 20 per cent tax bracket, can invest in the bonds as an alternative to some lower-interest rate offering of public and private sector bank FDs.

You can buy and sell tax-free bonds through your demat account. Sale of tax-free bonds attracts capital gains tax. If you sell the bonds within 12 months from the date of purchase, you are taxed on the gains based on your income-tax slab rate. If the bonds are sold after 12 months, the gains are taxed at 10 per cent without indexation benefit or at 20 per cent with indexation benefit.

Floating rate bonds

Another safe investment option for those wanting to diversify from bank FDs are the Floating Rate Savings Bonds 2020 issued by the Central government.

These bonds make semi-annual interest payments which are taxed as per your slab rate, and can be bought from some of the leading banks. The current interest rate on them is 7.15 per cent and is payable in January 2021. The interest rate is reset every six months. These bonds look attractive given that interest rates are expected to gradually move up. The only negative here is the long lock-in period of seven years.

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