Tax-free bond vs RBI 7.75% bonds: Which is better?

Published: May 27, 2020 at 10:02 am

A comparison between tax-free bonds that are available in the secondary market and RBI 7.75% bonds that can be obtained in the primary market. Which is better and how demand for tax-free bonds have quickly made them less attractive.

Kindly note, this is not a recommendation of either product. Unless you are a senior citizen with limited corpus and need either a source of regular income to top up a pension or need to safely park your money (with lock-in), do not buy these bonds.

They would make the portfolio less liquid and are not tax-efficient in the long run. For those far away from retirement, an arbitrage fund or debt fund can be more tax-efficient especially if you are in the 30% slab. Also see: Where should senior citizens invest in 2020? and also PM Vaya Vandana Yojana (2020) is now open: Key Features.

The RBI 7.75% bonds come with a lock-in and cannot be sold mid-term: 7 years for those less than 60; 6 years for senior citizens less than 70; 5 years for senior citizens less than 80; and 4 years for older investors.  Besides the normal half-yearly payout option, they come with a cumulative interest payout option. They can be purchased via major banks and Stock Holding Corp. of India.

The yield to maturity (YTM) of a bond represents the annualised return on the bond assuming all interest payouts are reinvested. This is technically not true if you get periodic payouts (annual in the case of tax-free bonds – the only option), but is an indication of the return on investment.

In the case of the RBI bond (cumulative option), the YTM is identically 7.75% before tax and 7.55%x(1-31.2%) = 5.33% after-tax for those in 30% slab (31.2% = 30%x(1+4%) with 4% being the cess). This is because the bonds have a lock-in.

In the case of a tax-free bond, you can buy them for a premium only in the secondary market. The lot size of these bonds would typically take them out of reach of the retail investor. When the price of the bond increases, you lose money on the transaction and your yield to maturity will fall.

Take for example HUDCO 9.01% tax-free bond maturing on13-Jan-2034. That is an awesome 9% interest payout for the next 14 years. However, this is on the face value of Rs. 1000. If you want this bond, you need to pay a premium of Rs. 1413. This would eat away most of your gains.

According to Edelweiss broking, the current YTM is only 5.07% which is lower than the RBI bond. This HUDCO bond has increased in price by about 11% in the last two months due to increasing demand. This will reduce the attractiveness of the tax-free bond.

Another example is IIFCL 8.91% coupon rate maturing Jan 2034. The current YTM is only 5.16%. In the last few months, the price has moved by Rs. 100. This is true for pretty much all tax-free bonds.

Unless one is looking for capital gains (from selling) it is always better to avoid the secondary market for receiving interest income. Low trading volumes and high impact costs will severely impact future interest gains. It is almost as if one is paying the tax upfront.

A bond, when purchased at face value, is simpler, cleaner and easy to understand. In any case, the RBI 7.75% bonds are currently more attractive than tax-free bonds in terms of yield, simplicity and cumulative option. The only downside is the lock-in.

If you are far away from retirement avoid such products as they the loss due to market forces and tax is too high and the portfolio becomes too illiquid to allow free rebalancing and risk management.

Chasing after returns in greed and chasing after safety in fear has the same impact on an investment portfolio.

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