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

Published: May 27, 2020 at 10:02 am

Last Updated on May 27, 2020 at 10:51 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.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

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.

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)