Differences between tax-friendly bonds

Don't just look at the rate of return some help in offsetting capital gains as well

Another season of tax-saving bonds is upon us. While Rural Electrification Corporation (REC) kicked this off last week, the Power Finance Corporation (PFC) issue opens on December 14. Others like National Highways Authority of India are likely to follow suit.

While these issues are a good substitute to fixed income products, all of these might not be meant for you. Financial planner D Sundararajan of Trendy Investments, says, “These bonds are meant for those in the highest tax bracket of 30 per cent.” Reason: These bonds will help save good money, while paying a fixed rate of interest for the very long term. REC offers a coupon rate of 7.72 per cent for 10 years and 7.88 per cent for 15 years, to retail investors. And PFC will pay 7.69 per cent and 7.86 per cent for 10 years and 15 years, respectively.

R Nagarajan, director (finance) of PFC, said, “These bonds are better than PPF because there is no lock-in. These bonds give a fixed rate of interest over the long term and can be bought and sold in the stock exchange. The only disadvantage is that if it is sold to someone, the buyer will earn 50 basis points less.”

Those in the 10 per cent bracket will be better off investing in other debt products like fixed deposits and company deposits, which are giving higher returns of 8.50 per cent (SBI's 10-year deposit) and 9.75 per cent (M&M's three-year company deposit), respectively. After-tax returns for those in this bracket will also be at par or higher at 7.65 per cent (fixed deposit) and 8.77 per cent (company deposit) than the returns given by these bonds. Across tax brackets, PFC officials claim, individuals will save anywhere between 8.50 to 11.30 per cent.

“These bonds can also help plan estate,” says financial planner Malhar Majumdar. Say, you invest Rs 10 lakh for 15 years, earning you a tax-free income of close to Rs 80,000 a year (as the bonds pay close to eight per cent yearly). You can put the interest income into other long-term instruments like PPF. At the end of 15 years, you would have made a substantial kitty for goals like children's education or marriage and retirement.

Another advantage with these bonds is that as we are expecting an interest rate cut in the coming year, their price may quote at a premium. As a result, over a period of time returns from these bonds will be higher than the coupon rate. But, to make capital gains, you will require to stay invested till maturity.

Many end up investing capital gains in these bonds, assuming they will be able to save tax on the gains. But, that’s not true. Bonds that help save capital gains are different from these. Tax-free bonds qualify for tax exemption under Section 10 (15) (iv) (h) of the Income Tax Act, meant only for the central government-approved specified bonds.

On the other hand, bonds, that help save capital gains are also called 54EC bonds as these are exempted under Section 54EC of the Act. The purpose of the two is different. So, while you can make small investments starting at Rs 5,000 in tax-free bonds, you have to make lump sum investments of up to Rs 50 lakh in 54EC bonds according to the Income Tax Act, within six months of sale of the capital asset like a residential property.