Should you invest in Tax-Free Bonds ??

“Ohh Man !! I did my tax saving investments 2 months back only. Otherwise I would have invested in these tax-free bonds. But now I can’t invest in them.” said Mahesh Kuntal, a 34 year old executive, working with a leading pharma company. He was having a casual discussion in tea-time with his colleague Kapil.

Kapil : What does tax saving investments have to do with this ?

Mahesh : We can only invest Rs. 1 Lakh in tax-free right ??

Kapil (smiling) : I think this is the most common problems with most of us. We call ourselves educated but we hardly have financial literacy. Let me clear few things here :

1. Tax Saving Investments and Tax-free investments are entirely different from each other.

 2. In tax saving investment, you get a deduction on the amount invested. Lets say, if you invest Rs. 1 Lakh in any of PF, PPF, ELSS, Insurance Premium, NSC, Tax Saving Bank FD etc, you would get a tax deduction upto Rs. 1 Lakh u/s 80C. But that does not mean that the returns would also be tax free. For example, the interest earned on Tax Saving Bank FD and NSC are taxable.

3. In Tax Free Investment, you don’t get a deduction on the investment made. However, the returns generated are tax free. i.e. they are not clubbed with your taxable income.

4. There is a limit of Rs. 1 Lakh for investment in tax saving products. However, there is no limit on investments in tax-free products.

Mahesh: I am understanding to some extent. But I have few more queries. If I don’t get a tax deduction, does it make sense to invest in a tax-free investment ?

Kapil : Well, it will depend on your tax slab. Lets say, you are in a 10% tax slab, you would get a 9.25% interest rate in a Bank FD (Pre-tax). The post-tax returns would be around 8.3%. Thus, it would be better to invest in a tax-free bond giving a yield higher than 8.3%. Currently you are getting around 8.5-8.6% on tax free bonds.

Likewise if you are in a 20% tax slab, then even if a Bank FD pays you 9.5% (pre-tax), your post tax returns will be 7.54% only. Thus, any tax free bond giving you returns higher than that would be beneficial for you.

And in case you are in a 30% tax slab, even a bank FD paying you 10.5-11% returns (pre-tax), your post tax returns will be 7.6% only. Again, a tax free bond will score over it.

Only if you are in a NIL tax slab, you may go for a bank FD or a taxable interest instrument as tax-free bond wont be much beneficial for you.

Mahesh : O Wow !! Never thought it that ways !! So now I am in 20% tax slab, and tax free bonds are giving yields closer to 8.6% these days. So they would definitely be a better choice than Bank FD. But I have one more query. How do these tax-free bonds compare with PPF ?

Kapil : Good Question !! Since you are a Football Fan, I will explain you this way. PPF loses the match with Tax-free bonds by 1-4.

Mahesh: Sounds interesting !! Please elaborate.

Kapil : Sure. PPF scores over Tax free bonds in only one aspect i.e. investments made in PPF would qualify under Sec 80C and investments made in tax-free bonds wont qualify.

However, Tax – Free Bonds score over PPF in 4 parameters :

  1. No Limit on investment : Suppose you have Rs. 10 Lakhs to invest. You cant invest them in PPF. But you can invest them in tax-free Bonds.
  2. Better Liquidity : Since the tax-free bonds are listed, you can liquidate them anytime. Whereas for PPF, you have lot of restrictions for liquidity.
  3. Opportunity of Capital Gains : If in future, there is a fall in interest rates (which is quite likely), you have an opportunity of earning capital gains from tax-free bonds. Lets say there is a fall of 1% in interest rates in the next one year, then you can expect a capital gain of 13-14% in a tax free bond. This capital gain would be in addition to the tax-free interest offered. This means you have an opportunity to earn a return of 21-22% from a debt instrument through tax free bonds.
  4. Fixed returns : As we know that PPF interest rates are linked to 10 Year G Sec yield, there is a chance that we may get less returns from PPF in future. Lets say if the Gsec Yield falls, then in future you might get only 6.5-7% interest on PPF. However, in case of tax free bonds, the interest being paid will be fixed i.e. if you buy a tax-free bond paying 8.6%, it will keep paying you 8.6% for the next 15 years (tenure of the bond). Also, On the contrary, fall in 10 year G Sec yield will earn us better returns in Tax-Free Bonds in the form of capital gains explained above.

Mahesh (happily): So all in all, tax free bonds score over several investment avenues. Especially people who are having taxable income. And in my case, I am already done with my tax saving investments. So this would in effect work like a tax saving investment for me, as I do not need to pay tax on the interest earned.  Thank you so much for sharing all this info, Kapil.

I will see that I break my FDs which are earning 8-9% taxable and invest in tax free bonds to earn 8-9% tax free. Even if I move Rs. 5 Lakhs from my taxable FDs to Tax Free Bonds, I will be able to save Rs. 5,300 every year for the next 15 years i.e. saving of Rs. 79,500 in the next 15 years. Plus, if I want to sell these bonds, I can make capital gains too. Thanks again !!

We look forward to your feedback and comments on the above article. Please feel free to contact us on saurabh@nidhiinvestments.com if you have any questions.

(The views mentioned in the article are personal opinion of the author)

Published by professorbajaj

Prof. Saurabh Bajaj is an Author, Mentor, Motivational Speaker and Wealth Planner. He has done his MBA from Narsee Monjee Institute of Management Studies (NMIMS) Mumbai, one of the top 10 management institutes in India. He holds the prestigious FRM (Financial Risk Manager) degree awarded by Global Association of Risk Professionals (GARP), USA. Till date, there are less than 15,000 professionals in the world, who have been honored with this degree. He has also been awarded CFGP (Chartered Financial Goal Planner) Certification by AAFM (American Academy of Financial Management). After his MBA, he joined J P Morgan, the second largest Investment Bank in the world. He has worked with J P Morgan as Risk Analyst for more than two years. Prof. Bajaj also holds an Advisory certification awarded by AMFI (Association of Mutual Funds of India). During his stint at Bombay Stock Exchange, he has handled Investment Management and Treasury operations of the BSE Corpus. He has set up an entrepreneurship venture in the field of Wealth Planning and Investment Consulting under the name “Nidhi Investments” and holds the profile of CEO. Prof. Bajaj sits on the Expert Panel of CAClubindia.com and MBAClubindia.com as Investment Expert. He is actively involved in investor education through his blog www.professorbajaj.com which has a readership from 78 Countries all over the world. His articles are also regularly published in caclubindia.com , mbaclubindia.com , totalca.com , charteredclub.com, bankbazaar.com and lawyersclubindia.com . He has been awarded the title of “Best Article Writer” from caclubIndia.com in Jan 2012 and has been selected amongst “Top 5 Technical Writers” from all over India in Feb 2013. He has been invited by various TV Channels like SPIN TV, CNBC TV18, UTV Bloomberg Etc for programs like "Expert Advice" , "What Markets Want ", "Budget Analysis" etc. He has been invited by Several organisations like Lions Club, Rotary Club, Agrawal Welfare Foundation, Rajasthan Mandal, Agroha Vikas Trust, Union MF, UTI MF, Arthamitra Gurukulam, Vidyalankar Institute of Technology etc for expert lecture on "Smart Investing", "Life is A Celebration", "Financial Freedom", "The Digital IFA" etc. He was ranked 8th Merit at All India level NMAT which got him selected for MBA programme at NMIMS, Mumbai. He did his MBA with Capital Markets as his specialisation. Soft Skills has become an inevitable part of every selection process and teaching learning process these days. The students from small towns and tier II cities, in spite of being talented and well equipped with technical skills, are seen struggling in the selection process. This is because of their lack of exposure to these soft skills. Mr. Bajaj has a zeal for training candidates to develop these skills and has been imparting the same on since last two years. This zeal and passion inspired him to set up his own firm called “Knowledge Circle” which aims to train candidates for soft skills. Till date, he has trained more than 5000 participants from over 220 organizations across various fields of soft skills. He has been associated with MSBTE (Maharashtra State Board of Technical Education) to conduct Soft skills training workshop for the faculties of Polytechnic Colleges in Entire Maharashtra (Mumbai Region, Pune Region, Aurangabad Region and Nagpur Region) since last 8 years. He has also been associated with ICAI (Institute of Chartered Accountants of India) for training CA Students on various topics related to Communications skills, Group Discussions etc. He was invited by Fr. Agnel Polytechnic College, Vashi for a motivational workshop for faculties. He was also invited by Vivekanad Polytechnic College for "Communication Skills and Email Etiquette" training for non-teaching staff. Apart from these, he has conducted “Capacity Building Soft Skills workshop for Faculties” at ITI Gunj, ITI Pusad, ITI Digras and ITI Umarkhed. This was the first ever soft skills workshop for faculties in the history of ITI’s in Vidarbha. He was also invited by Shivaji Education Society to conduct similar Soft skills workshops for the faculties and office staff of Shivaji Junior College Pusad, Shivaji High School Pusad, Shivaji Vidyalaya Belora and Shivaji Vidyalaya Bhojla. He has conducted training workshop on “Effective Presentation Skills” for the relationship managers of HDFC Mutual Fund, Andheri Branch, Mumbai. He has also been invited at College of Management and Computer Science, Yavatmal, College of Dairy Technology, Warud, B N College of Engineering, Pusad, B D College of Engineering, Wardha, College of Engineering and Technology, Akola, Dr.N.P.Hirani Institute of Polytechnic, Pusad etc. for the Guest lecture on “Developing Interview Skills”.

7 thoughts on “Should you invest in Tax-Free Bonds ??

  1. Very timely given the tax free instruments lined up for subscription! I did not understand the 3rd point you mentioned on Capital gains – usually, if the yield goes low, the bond value price increases, isn’t it ?

    1. Thanks for your valuable insights Lalitji.

      You are right. When the yield goes low, bond value increases. It means, if you invest Rs. 100 today, tomorrow you might be able to sell the bond at 112-113. This Rs. 12 will be your capital gain in addition to the interest rate that you get from the bond.

      Hope this is helpful.

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