Bond is a debt instrument in which an investor loans money to an entity (corporate or governmental) that borrows the fund for a defined period of time at a fixed rate. Tax-free bonds: One should not confuse tax-free bonds with infrastructure bonds, which enjoy tax deduction under Section 80CCF which have already been discontinued from the FY11-12 or capital gain bonds offered by REC and Nabard. Tax-free bonds mean its interest is not to be taxed in a tax free bond. Moreover, if you hold on to the tax-free bonds till maturity, you suffer no tax during the entire tenure of the bond and get full benefit of the higher rates. A word of caution of here is that if you exit and redeem your investment in a tax free bond through selling them in the secondary market, any gain arises from the sale of  these bonds  will be treated as capital gain and will be taxed depending on the holding period of the bond.
Arun is a pretty conservative investor and has been parking his money in bank fixed deposits (FDs) since long time. Today, it is difficult to get more than 9% pa for long-term FDs from banks for him. He is, now earning more than Rs10 lakh annually and, hence, his tax slab has, now escalated in the highest tax bracket (30%). It means that his effective post-tax return from FDs is left only 6.3% pa.  He is, now looking beyond the bank fixed deposits (FDs) where he could park his funds which give more than post-tax 6.3% pa in debt instruments.
A friend told him to look at tax-free bonds from government-owned companies that will be hitting the market in FY13. Before leap to tax-free bonds, Arun needs to understand the difference between FDs and tax-free bonds to assess whether they really suit him. Let us analyse what these bonds offer and who should invest in these tax-free bonds:
Post-tax Returns
Putting a part of your debt instrument investment must always see in terms of post-tax return. Tax-free bonds must certainly a good bet for those in the highest tax bracket, say 30%. With the retail limit having been raised from Rs5 lakh to Rs 10 lakh per issue, many investors may benefit from safely locking some chunk of their savings in tax-free bonds for their long-term goals. For those in the 20% tax bracket, it may not work as well as the difference in post-tax FD versus tax free bonds coupon may be less than 0.5%. Tax-free bonds will marginally beat post-tax FD returns considering the current rates and, hence, still an option worth considering. They are certainly not attractive for investors in the 10%, or no-tax bracket. They can stick with good traditional FDs. Senior Citizens get a higher interest rate for bank FDs (0.5% to 1%, depending on the bank) and also may come under a lower tax slab for their income; tax-free bonds may not suit them either.
Liquidity
Liquidity means premature withdrawal which is available in tax-free bonds, can be sold and bought in the secondary market before the maturity date; you may get an amount higher or lower than the issue price, depending on the interest rates prevalent at that time. On the other hand, FD will give the principal back along with interest calculated at the interest rate for that period and you have to pay certain penalty to the tune of 1% depending upon the banks norms. Though, the principal amount of bonds is not guaranteed except at maturity, it can be viewed as a way to diversify your debt portfolio.

Behaviour of Interest

While bank FDs having no variation in the interest rate irrespective of any fluctuations in the interest rates and bond prices. There will be varying impact on bonds based on the risk perception of the market about the bonds and their issuer. One key factor for assessing whether to go for tax-free bonds now or later is a call on the movement of interest rate.
There is an inverse relationship between interest rates and bond prices.  If interest rates decline, the bond value will rise and vice-versa. But this assumption may or may not hold good. If you asses that the rate cycle has peaked, it is good time to subscribe or buy bonds in the secondary market. Interest rates fluctuations should not bother you, if you have planned to hold the purchased bonds for the full term, otherwise you may sell the bonds when the rate of interest is low. While selling bonds in the secondary market is subject to capital gains tax as outlined above. Only the interest on them is non-taxable.
Re-investment Risk
Banks FDs are inherited in cumulative option as their interest usually gets compounded every quarter, hence it does not carry interest re-investment risk. It assures you that the quarterly interest is re-invested at the same interest rate, to help you increase the yield but subject to pay tax on the interest. Tax-free bonds will pay half-yearly or yearly interest which you may want to plough back in a bank FD or any other debt fund, if you want to earn on the interest income as well.
Step-down Clause
Since, bonds list and trade on the market, and step down clause in bonds restricts those investors who sell the bonds in the secondary market. If they sell its before maturity, coupon rate will go down by 50bps automatically. This means a lower selling price. It is obviously to encourage genuine investors to subscribe and discourage those trying to make a quick buck by selling them in the secondary market.
Conclusion
Whilst subscribing these bonds, Arun will get an additional 1% pa which may not look great but it the equivalent of 16% increase in returns. From his investment in bank FDs, Arun makes approximately Rs3 lakh annually in interest after tax. If he shifts one-third of his debt investment to tax-free bonds, Arun will make an additional Rs16,000 per year net of taxes which can really suit him. Hence, if you are interested to buy tax-free bonds, you have the choice of subscribing to the new offerings or buying bonds issued last year from the secondary market, finding out which is a better option may not be simple. Just like any investment, you will need to do your homework to understand the risk reward ratio.
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Suresh Kumar Narula

SEBI Investment Advisor, Founder & Principal Financial Planner at Prudent Financial Planners
Suresh K Narula is founder and Principal Financial Planner at Prudent Financial Planners. He has earned the professional CERITIFIED FINANCIAL PLANNER and got registered with SEBI as Investment Advisor. He writes on personal and financial planning articles and got published in Dainik Bhaskar, Business Bhaskar and The Financial Planner's Guild, India. He is also a member of Financial Planner's Guild India ( An association of practicing SEBI registered Investment advisers) to create awareness about Financial Planning in general public, promote professional excellence and ensure high quality practice standards. Suresh received his an M.com from Himachal Pardesh University and an MFC from Punjab University, Chandigarh. He can be reached at info@prudentfp.in
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