Debt funds may be better than tax-free bonds

The trade-off is between higher yields and liquidity vis-a-vis tax benefits. Do the maths before investing

Public sector undertakings such as Indian Railway Finance Corporation and National Highways Authority of India will soon come out with their tax-free bonds. The biggest advantage for investors is that the interest earned from these bonds is entirely tax-free. But the disadvantage is that these bonds lack liquidity. While investors can sell them through exchanges since they are listed bonds, it becomes difficult to do so as they are not traded frequently.

One way to get around this is to invest in an active bond, say an income fund, that invests in the taxable bonds of the same PSUs. This way you are assured of the same credit quality and higher yields. Yields on taxable bonds can be about 100 basis points higher than tax-free bonds.

"Investing in the taxable bonds of the same PSUs make more sense as yields are higher. This is a strategy we have been following for our debt funds for some time now. And if you remain invested for three years, you will get benefit of indexation,'' says Namdev Chougule, Executive Director, Head-Fixed Income, J P Morgan Asset Management.

For instance, JPMorgan has non-convertible debentures of PSUs like Power Finance Corporation, Rural Electrification Corporation, Airports Authority of India, IRFC, Power Grid Corporation of India, etc. All of these are companies also issue tax-free bonds.

The trade-off is between the higher returns generated by the mutual fund and the post-tax benefits of tax-free bonds, says Sudip Bandyopadhyay, MD and CEO, of Destimoney Securities. "Even in a debt fund it is possible to reduce the tax by opting for the growth option and holding your investment for three years. But it will attract long-term capital gains after three years. However, the clincher for mutual funds is the liquidity. Investors can sell at any point of time. In case of tax-free bonds they are stuck with the bonds if they can't find buyers,'' he says.

Besides with interest rates going down and bond prices going up, both debt funds and tax-free bonds will give the benefit of capital appreciation. So savvy investors can consider the mutual fund route, he adds.

Let us assume an investment of Rs 1 lakh in both tax-free bonds and income funds. The yield on the tax-free bonds at 8.5 per cent and the yield on income funds at 9.5 per cent. The tax-free bond if sold after one year will give you Rs 1,04,500, after capital gains tax of 10 per cent plus interest of Rs 8,500. The income fund will give you post-tax returns of Rs 1,06,650. If you sell after three years, the tax-free bond will give you Rs 1,09,000, after capital gains plus interest of Rs 25,500. The income fund will give you Rs 1,27,932 with indexation. But remember that selling the bond can be difficult. So, investors will have to hold them till maturity to get the tax benefit. On the other hand, income funds can generate more during the three year period due to market volatility. Also, for the sake of calculation indexation figure has been assumed to increase by 7 per cent.

Those investing in mutual fund will have to keep in mind intermediation costs and other expenses, which can eat into the gains, points out Jyoteesh  ?EVP & Head Marketing, Distribution & Product at HDFC Securities. "If you invest directly in tax-free bonds it is transparent and you know what you are investing in. But in case of mutual funds often investors don't know what kind of papers the fund is investing in,'' he says.

Tax-free bonds are issued for long term periods of 10-20 years and are preferred by high networth investors. This time around experts feel that a lot of money from equity gains could flow into tax-free bonds as and when they hit the markets.

If you sell tax-free bonds before maturity, the capital gains will be taxed. So, investors will have to hold them till maturity to get the tax benefit.