Web Exclusive: A layman's guide to Tax Free Bonds
Rural Electrical Corporation (REC) has filed draft prospectus with SEBI for issuance of tax free bonds on 22 November, 2012. With this it won’t be inappropriate to say that season for issuance of tax free bonds by institutions, authorized to do so as per mandate given by the Government of India in the budget of current financial year, has begun.
It is pertinent to note that the previous Finance Minister, Pranab Mukherjee, had announced the proposal of allowing state-run companies to issue tax-free bonds in the Budget for 2012-2013. Under that proposal 10 companies were given a total kitty of bonds worth Rs 60,000 crore. This includes issue of Rs 10,000 crore bonds each by NHAI, IRFC, IIFCL and the power sector. While bonds of Rs 5000 crore each was allocated for HUDCO, National Housing Board, SIDBI and port developers.
What are tax free bonds? Tax free bonds are those bonds in which interest earned by the investor is exempt from tax. Tax free status of interest income as per Section 10(15)(iv)(h) of the Income Tax Act, 1961. It is important to note that tax free bonds are different from tax saving bond because in case of tax saving bonds, the investor gets to save tax under section 80CCF on the investment made by him in these bonds. Tax free bonds do not provide any benefit of tax savings but only interest earned on these bonds is tax exempt.
Who should apply? These bonds provide good return option for investors for a long period of time. The tax savings bonds issued last year provided 8.20% to 8.35% for investment horizon of 10to 15 years. Since there is no tax on interest earned, these bonds are much more attractive than bank fixed deposits.
For a person in 30% tax slab, a 9.5% percent rate on bank FD, effectively works out to be only 6.65% while the rate offered by these bonds were in range of 8.20% to 8.35%. Any investor looking for safe, long term and better than bank deposit return should go for these bonds. Since these bonds are tradable on stock exchanges, they also provide better liquidity than bank deposits.
Factors to consider before applying for tax free bonds
What are factors that an investor needs to consider before applying for tax free bonds? Are all tax free bonds alike? To understand the best suited tax free bond for a particular investor, the following aspects need to be looked into:
Minimum application size: Last year when tax free bonds were issued by NHAI and PFC, the minimum application size was kept at Rs 50000.This means that only those investors willing to invest Rs 50,000 could have applied for these bonds. The tax free bonds issued by REC on the other hand had a minimum application size of Rs 5,000 only. This brings in the aspect of affordability. So before applying for these bonds, it is suggested that an investor checks affordability in terms of minimum application size.
Coupon offered on bonds: While the coupon offered on these bonds are almost similar, it makes sense to go for those bonds which offer higher coupon. Last year HUDCO had offered 8.35% coupon on a 15 year bond, while NHAI bonds had coupon of 8.30%. Though this is a not substantial difference, over a period of 15 years, this difference will become significant especially if the amount applied is higher.
Issue size: Tax free bonds with higher issue size have higher liquidity post listing. Higher liquidity means that an investor wishing to sell bonds in the second market can easily sell them. If all other factors are same, an investor should opt for a bond with higher issue size.
There is a lot of homogeneity in the tax free bonds issued by the authorized institutions and there are very few differentiators. Hence, an investor needs to analyse differentiators smartly before applying for these bonds.
The author has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance.