Do not invest in tax free bonds if your retirement is a long way off. Even if are retiring soon, do not invest in these unless you have thoroughly evaluated your options.
There, I said it. That is the message of this post. I have been wanting to say that for a long time. Ever since I had a difference of opinion with a popular blogger for publishing post after post about tax free bonds without offering any kind of perspective on who should invest? and who should not?
I soon realised that he is not alone. There is a lot of similar nonsense available online, all in the name of financial literacy.
If you are considering an investment in tax free bonds, I suggest you ask yourself the following questions:
For those far from retirement:
- Why do I want to invest in a product that offers no compounding?
- I am thinking of investing only because I have a lump sum with me. What am I doing with a lump sum anyway in the first place? (Its okay if you have just received it!) Should I not have reviewed my financial goals and invested it accordingly, immediately after I received the lump sum?
- Is this lump sum tied to any financial goal at present? If not, should I first not worry about that and access where this lump sum fits in?
- Why am I interested in a tax free bond? Is it because the interest is tax free? Is it because I feel the that the principal would be safe at the end of the tenure?
- Suppose I do invest, what am I going to do with the interest that will be paid out each year?
- Do I invest it in fixed deposits? Or do invest in equity mutual funds? Perhaps in PPF?
- Am I sure that the net return I will get from this arrangement will be enough for my financial goals?
- Will I be disciplined enough to invest the interest payouts without fail? That would mean I have a decent emergency fund and adequate health insurance.
- Can I do better? Suppose I invest the lump sum in an equity mutual fund (or the same instrument you want to invest the payouts in), will I be able to get a higher post-tax corpus?
For those close to retirement:
- Am I thinking of investing in these bonds because they provide regular income?
- Is 'regular income', what I want in retirement? Should my 'pension'/annuity not match inflation?
- Is it wise to lock up a lumpsum in such an instrument for such a long period?
Points to ponder for those far away from retirement:
- If you planning to reinvest the payouts in an equity mutual fund, because you are 'scared of equity' investments, think again! People who are uncomfortable with equity investing are unlikely to continue investing for 10, 15 or 20 years. Such people get scared when they see the value of their fund in red and exit. In fact, most mutual fund distributors claim that the average duration of a SIP is 3 years! Are you sure you will follow through with your plan? If you don't, you will end up complicating your financial life and taxes in any other instrument may reduce your returns.
- If you planning to reinvest the payouts in an equity mutual fund, because you want to protect the principle, think again! What are you protecting against? The volatility of the stock market, inflation?
- The only thing you should worry protecting against is inflation. The best way to do that is to ensure your lump sum is invested in an instrument that fetches the best post-tax returns after a long time. Volatility is a necessary price to pay for beating inflation.
- What about directing the reinvestment to a PPF account? Smart idea .... if you are happy with a post-tax CAGR of about 8.6% from the debt component of your portfolio. Of course the money will locked away for 15 financial years. So do be sure you can afford that!
- Want to check if reinvesting payouts is better than investing the lump sum? Use this Tax Free Bonds: Interest payout reinvestment calculator.
Points to ponder for those close to retirement:
- If you planning to invest in these bonds, because you are looking for regular income and because some 'expert' said such bonds are suitable for those looking for regular income, think again!
- Regular income in retirement is not a luxury to be desired, but a fate to be abhorred!
- A retiree who locks up all his retirement corpus in regular income yielding instruments faces a grim future. Inflation will diminish the buying power of your regular income slowly and surely.
- A retiree must invest consider such regular income instruments if and only if he/she does not have a corpus large enough to ensure financial independence in retirement. In such a case there is no option, but to choose from annuity products from insurers, tax-free bonds, monthly income schemes, senior citizen saving schemes etc.
- Locking a corpus in such instrument should be the last resort not the first step!
Bottomline for any investor: Analyze before you invest! (Wow! such novel advice far removed from commonsense!!)
What do you think? Do you agree with my views? Can you think of a smart way of reinvesting the interest payouts?