Smart Investing: Lock into tax-free bonds for higher yields than FDs
Investing in tax-free bonds and target maturity funds can be a better option than bank fixed deposits.
With the volatile markets and rising interest rates, smart investors, especially those in the highest tax bracket, are opting for tax-free bonds to earn higher post-tax returns than bank fixed deposits. Yields on tax-free bonds have moved up to around 6% now, as compared with around 4.5% a year ago. In contrast, interest on bank fixed deposits is in the 4.5-5% range in the short-term.
Tax-free bonds launched by public sector companies are an ideal instrument for risk-averse retail investors. Investors can now buy tax-free bonds of public sector companies such as NHAI, PFC, REC, IRFC, Hudco, Nabard, etc, from the stock exchange; these were issued by the government between 2012 and 2016, for tenures up to 20 years. However, the supply of tax-free bonds is limited as there have been no fresh issuances over the last six years.
Tax-free bonds: Prime credit quality
Risk-averse investors always prefer the safety of capital and liquidity while investing in fixed income products. As tax-free bonds of public sector companies are rated AAA, indicating prime credit-quality and highest safety, investors prefer to lock-in money for long-term needs. Experts say tax-free bonds have long tenures, typically maturing after 10, 15 or 20 years, and are an ideal investment to build a retirement portfolio. The interest is paid on a yearly basis to the investor’s bank account directly and, at maturity, they will get back the face value invested.
Experts say in a rising interest-rate regime, investors should lock into tax-free bonds for the long term to earn higher returns. Also, long-duration bonds reduce reinvestment pressures. In tax-free bonds, while the investor does not get any tax exemption under Section 80C of the Income Tax Act, 1961, the interest accrued is completely tax-free under Section 10(15)(iv)(h).
The tax-free status of these bonds will remain till maturity. While the interest payments on these bonds are free of tax, there would be capital gains tax if an investor sells before maturity at a profit. The investor will have to disclose the interest earned in their income tax return as exempted income. These bonds are traded in the stock exchange (BSE and NSE) only through demat accounts in Lots of `10 lakh each. Bond-holders can sell them to another individual, and it is quite similar to trading shares in a stock market. However, there is no Call or Put option in most of them, and buyers must hold till maturity as liquidity may not always be readily available.
Target maturity funds
Target maturity funds invest in government securities, bonds of public sector companies and state development loans. The default risk is lower as compared with other debt funds, and the duration of the fund keeps falling with time. The bonds in the portfolio are held to maturity and all the interest payments are reinvested in the fund.
As the duration rolls down over time, the volatility reduces as the fund gets closer to the target maturity. So, investors who are targeting specific segments of the yield curve are able to invest in these funds without being locked in till maturity. Experts say investors can make target maturity funds part of their portfolio if they want higher predictability of returns and have a longer time horizon.
Rising Rates
Tax-free bonds launched by public sector companies are an ideal investment option to build a retirement portfolio
Post-tax returns for tax-free bonds are higher than those of bank fixed deposits
The supply of tax-free bonds is limited as there have been no fresh issuances over last six years
In a rising interest-rate regime, investors should lock into tax-free bonds for the long term to earn higher returns
These bonds are traded in the stock exchange (BSE and NSE) only through demat accounts in lots of Rs 10 lakh each