INVESTING IN TAX FREE BONDS

[Dr. Sanjiv Agarwal]

These days, state owned companies are once again back in market with issue of tax free bonds, i.e., the bonds on which interest earned is tax free. No income tax is payable on such interest earned, although the interest rate is also lower.

The taxable bonds recently offered provide a net return of 7.2% to 7.9% which is tax free. Normally in other investments like fixed deposit etc., interest income is subject to Income Tax. These tax free bonds have been or are being issued by entities such a Rural Electrification Corporation (REC), Power Finance Corporation (PFC), India Infrastructure Finance Co (IIFC), Housing and Urban Development Corporation (HUDCO) etc.

While a yield of about 7.5 percent may not be very exciting for investors but it should be borne in mind that such an yield is totally tax free. A typical fixed deposit may yield an interest of, say 9 percent but it would be subject to Income Tax which may result in post-tax yield of 7.20% only on 20% tax slab and a mere 6.30 % on a slab of 30 %. Thus, in case of present yield of around 7.5 % in tax free yields, investors don't see much excitement so as to channelize their investment into tax free bonds. Compared to 2011also, the yield is lower as it was in the range of 8-8.4 % last year. Who knows, interest rates may go down further next year.

Yield in normal course			Yield in tax free bonds (%)
Pre - tax yield (%)	Post Tax - yield (%) (@20% tax)	Post Tax - yield (%) (@30% tax)
8.00	6.40	5.60	7.5
8.50	6.80	5.95
9.00	7.20	6.30

Also, in such investments, liquidity plays a major role as such investments are made only by those investors who have surplus liquidity and they only park the funds to have safer parking or better yields.

Such tax free bonds have been designed to encourage long term investment in infrastructure as announced in 2012 budget. However, such bonds do not attract any income tax deduction from total income or other benefit of tax rebate. Also such bonds are neither infrastructure bonds which allow savings based deduction in income nor investments which qualify for exemption from capital gains tax. Further, such typical bonds provide yearly interest whereas fixed deposits provide for cumulative option. taxmanagementindia.com

Investors who wish of diversify their fixed earning investments may distribute some investments in other fixed earning instruments as they may be still safer from other private investments of course, availability of surplus funds should be there.

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