Tax-free bonds give better returns than tax-saving FDs

The higher the tax bracket, the better the yields for these instruments

Tax-free bond issues are witnessing record subscription. In the latest development, National Highways Authority of India (NHAI)’s Rs 10,000-crore issue was subscribed 2.4 times. Investors had similarly lapped up earlier ones by NTPC, IRFC and Power Finance Corporation.

Investment advisors and financial planners say investors are choosing these issues over bank fixed deposits (FD) for the attractive after-tax returns that tax-free bonds offer. “We are in a downward interest rate cycle. The returns on fixed deposit can go down further, and so investors are looking at these issues to lock in their investments at the current rates,” says Suresh Sadagopan, founder, Ladder 7 Financial Advisors.

It’s not only the higher post-tax returns that are attracting investors to these bonds. These bonds are issued by the government-backed companies that guarantees safety of capital, says Malhar Majumder, partner and consultant at Positive Vibes Consulting and Advisory. This is as good as putting money in a top public sector bank line State Bank of India (SBI). Then, there’s guarantee of stable returns for 10-20 years, depending on the tenure investors choose. But, the biggest reason for the investor frenzy is that they’re not available on demand. Majumder says there wasn’t a single issue in 2014.

Varsha Vijay, however, is confused. She is self-employed and invests in a long-term tax-saving fixed deposit that offers tax deduction. The recent issues of tax-free bonds work out to be a better option for individuals like Varsha.

Assume that a person invests Rs 1.5 lakh, the limit available under Section 80C, in a 10-year fixed deposit. SBI offer seven per cent returns on such FDs. If she is in a 10 per cent tax bracket, the returns she makes in a bank FD over a decade will be Rs 1,26,327. Add to this the Rs 15,000 tax benefit she has got, and the effective interest rate comes to 6.86 per cent. If she invests the same money in NHAI’s issue for 10 years at 7.39 per cent interest, her returns would be Rs 1,56,006.

The effective interest rate for people in the higher tax bracket increases if you compare the returns taking the tax benefits into account. For someone in the 20 per cent tax bracket, an investment of Rs 1.5 lakh in tax-free FDs would have got 6.77 per cent returns effectively. For those in the highest income tax bracket, the effective returns would be 6.71 per cent. Their investment in the NHAI bond would still fetch them 7.39 per cent interest.

Many working individuals exhaust their Section 80C benefit in Employee Provident Fund and Public Provident Fund and housing loan, leaving little scope to invest in tax-saving FDs. If the tax benefit is taken away, tax-free bonds scores even higher in terms of returns.

Liquidity is the only issue that investors can face with these bonds. Although they are listed on stock exchanges, once the issue is over, an investor might not find buyers at a suitable price.