Tax-free Bonds: Do not invest if your retirement is a long way off!

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!!)

Your Take:

What do you think? Do you agree with my views? Can you think of a smart way of reinvesting the interest payouts?

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55 thoughts on “Tax-free Bonds: Do not invest if your retirement is a long way off!

  1. bemoneyaware

    Totally agree with you.
    Recently read that people are breaking their FDs to invest in the tax free bonds (which are closing before their due date). It seems to be herd mentality and media coverage of interest rate going down.

    Reply
  2. bemoneyaware

    Totally agree with you.
    Recently read that people are breaking their FDs to invest in the tax free bonds (which are closing before their due date). It seems to be herd mentality and media coverage of interest rate going down.

    Reply
  3. pattu

    This is because of the crap that abounds in the name of financial literacy. CFPs who make a big deal about 'spreading awareness' write article after article about these bonds without providing any kind of perspective. They are either incompetent or are selling these bonds.

    Reply
  4. pattu

    This is because of the crap that abounds in the name of financial literacy. CFPs who make a big deal about 'spreading awareness' write article after article about these bonds without providing any kind of perspective. They are either incompetent or are selling these bonds.

    Reply
  5. Ramamurthy

    The main attraction is that the income is tax exempt.From such schemes which have been announced so far,for persons in the in 30% tax slab the post tax income is around 12%.The lock in period is 10 years.The possibility of prematurely getting out is remote.
    Apart from direct equity investments such persons can think of investing in Fixed Maturity plans of Mutual Funds or debt funds which can also provide the same returns with a lock in period of 2 to 3 years.

    Reply
    1. pattu

      Yes I agree with your general observations. How is post-tax income 12%. Since the income is tax-free, if the coupon rate is 9%, what we get is 9% irrespective of tax-slab. FMPs can be used, but over 15-20 year period, repeated reinvestment will entail taxes. There is also the risk of variations in FMP performance.

      Reply
  6. Ramamurthy

    The main attraction is that the income is tax exempt.From such schemes which have been announced so far,for persons in the in 30% tax slab the post tax income is around 12%.The lock in period is 10 years.The possibility of prematurely getting out is remote.
    Apart from direct equity investments such persons can think of investing in Fixed Maturity plans of Mutual Funds or debt funds which can also provide the same returns with a lock in period of 2 to 3 years.

    Reply
    1. pattu

      Yes I agree with your general observations. How is post-tax income 12%. Since the income is tax-free, if the coupon rate is 9%, what we get is 9% irrespective of tax-slab. FMPs can be used, but over 15-20 year period, repeated reinvestment will entail taxes. There is also the risk of variations in FMP performance.

      Reply
  7. Bhaskar

    I humbly disagree. Any investments must be analyzed in these buckets
    - Time frame
    - Liquidity
    - Safety
    - Diversification

    and for me tax-free bonds are the way to go. I invest the interest received to direct stocks and so doing a time & price based SIP. At such high valuations, it is not prudent to start a new MF folio if he has 20+ year timeframe.

    Reply
    1. pattu

      This post is directed at those who sit on large piles of cash and invest in such bond only because the payout is tax-free, without aligning their investments to their financial goals. Time frame, liquidity, safety and diversification are not buckets but are aspect of investing deeply inter-related to each other.

      If you are convinced about what works for you, whom am I to say anything?!
      I will say this much though: SIP investing or MF investing over a 20 year time frame does not depend on valuations. It only depends on the disciple to stay invested. Over this long a time frame, returns are likely to beat inflation no matter what the current valuation is.

      Reply
  8. Bhaskar

    I humbly disagree. Any investments must be analyzed in these buckets
    - Time frame
    - Liquidity
    - Safety
    - Diversification

    and for me tax-free bonds are the way to go. I invest the interest received to direct stocks and so doing a time & price based SIP. At such high valuations, it is not prudent to start a new MF folio if he has 20+ year timeframe.

    Reply
    1. pattu

      This post is directed at those who sit on large piles of cash and invest in such bond only because the payout is tax-free, without aligning their investments to their financial goals. Time frame, liquidity, safety and diversification are not buckets but are aspect of investing deeply inter-related to each other.

      If you are convinced about what works for you, whom am I to say anything?!
      I will say this much though: SIP investing or MF investing over a 20 year time frame does not depend on valuations. It only depends on the disciple to stay invested. Over this long a time frame, returns are likely to beat inflation no matter what the current valuation is.

      Reply
  9. Novice

    Dear Pattu, I think your XIRR calculator easily does the job of calculating returns of Tax Free Bonds with reinvestment. I am assuming those reading your blog are familiar with compound interest formula and how to use it to calculate the final return value!

    Reply
    1. pattu

      Yes you are right! That is I will be using for the reinvestment calculation! I learnt a couple of strange things about XIRR while making it

      Reply
  10. Novice

    Dear Pattu, I think your XIRR calculator easily does the job of calculating returns of Tax Free Bonds with reinvestment. I am assuming those reading your blog are familiar with compound interest formula and how to use it to calculate the final return value!

    Reply
    1. pattu

      Yes you are right! That is I will be using for the reinvestment calculation! I learnt a couple of strange things about XIRR while making it

      Reply
  11. pattu

    I understand what you are saying but I don't think it is correct to compare that way. First we must compare products which are alike. So we can only compare post-tax returns of tax-free bonds with that of tax-saving bonds or any other bond. Second we compare post-tax returns only. Adding the tax saved (by not investing in a taxable product) to the CAGR is artificial.

    Reply
  12. pattu

    I understand what you are saying but I don't think it is correct to compare that way. First we must compare products which are alike. So we can only compare post-tax returns of tax-free bonds with that of tax-saving bonds or any other bond. Second we compare post-tax returns only. Adding the tax saved (by not investing in a taxable product) to the CAGR is artificial.

    Reply
  13. Kapil Tiwari

    The old 8% tax-free RBI bonds (not the current ones) were of 5-year tenure, had a cumulative option (compounding) and were issued by the Govt. of India itself. The new tax-free bonds pay out interest annually (where to re-invest each year?), are of 10, 15, 20 - year tenure (can we trust the Govt over such long periods? Remember Unit Trust of India?) and are being issued by public sector undertakings (not as reliable as RBI or GOI, are they?).

    While the old tax-free RBI bonds were much in the league of PPF & EPF, these new tax-free bonds are nothing to die for if we are planning to accumulate a corpus for retirement. Even a retiree will have to continue to accumulate, as this fixed annual pay-out of interest from these bonds will soon lose value because of rising inflation.

    This is how I perceive the new tax-free bonds of NTPC, REC, etc.

    Reply
  14. Kapil Tiwari

    The old 8% tax-free RBI bonds (not the current ones) were of 5-year tenure, had a cumulative option (compounding) and were issued by the Govt. of India itself. The new tax-free bonds pay out interest annually (where to re-invest each year?), are of 10, 15, 20 - year tenure (can we trust the Govt over such long periods? Remember Unit Trust of India?) and are being issued by public sector undertakings (not as reliable as RBI or GOI, are they?).

    While the old tax-free RBI bonds were much in the league of PPF & EPF, these new tax-free bonds are nothing to die for if we are planning to accumulate a corpus for retirement. Even a retiree will have to continue to accumulate, as this fixed annual pay-out of interest from these bonds will soon lose value because of rising inflation.

    This is how I perceive the new tax-free bonds of NTPC, REC, etc.

    Reply
  15. Ramamurthy

    Where is the question of repeated reinvestment in FMP please?
    When once the maturity period ends the investor can take back the money with accrued interest.Am I wrong?

    Reply
    1. pattu

      You understanding is correct wrt FMP. I am referring to a comparison bet. FMP and these bonds.
      An FMP can be thought of a bond with cumulative option. So we cannot compare this with tax-free bonds in the first place. Secondly the durations are different. Ignoring the difference in nature of investment, if i want to compare FMP investment with tax-free bond investment with payouts reinvested then I must consider at least 3 FMP durations to match the lowest bond tenure of 10Y. So this means the lumpsum would get reinvested at least twice.

      Reply
  16. Ramamurthy

    Where is the question of repeated reinvestment in FMP please?
    When once the maturity period ends the investor can take back the money with accrued interest.Am I wrong?

    Reply
    1. pattu

      You understanding is correct wrt FMP. I am referring to a comparison bet. FMP and these bonds.
      An FMP can be thought of a bond with cumulative option. So we cannot compare this with tax-free bonds in the first place. Secondly the durations are different. Ignoring the difference in nature of investment, if i want to compare FMP investment with tax-free bond investment with payouts reinvested then I must consider at least 3 FMP durations to match the lowest bond tenure of 10Y. So this means the lumpsum would get reinvested at least twice.

      Reply
  17. Ramamurthy

    I dont agree. I am comparing post tax returns of Tax Free Bonds with post tax returns of say, FMP.Both options in my opinion are comparable.

    Reply
  18. Ramamurthy

    I dont agree. I am comparing post tax returns of Tax Free Bonds with post tax returns of say, FMP.Both options in my opinion are comparable.

    Reply
  19. Ramamurthy

    Please see the lock in period.Tax free bonds have a lock in period of 5 to 15 years.FMP have 1 to 3 Years.Which would you prefer?

    Reply
    1. pattu

      I am not disagreeing with you. I am just saying, that if we wish to compare FMP with bonds we will have to take into account the nature of invest and duration.

      If I had to choose bet. just these two, I will choose FMP like you would.

      Reply
  20. Ramamurthy

    Please see the lock in period.Tax free bonds have a lock in period of 5 to 15 years.FMP have 1 to 3 Years.Which would you prefer?

    Reply
    1. pattu

      I am not disagreeing with you. I am just saying, that if we wish to compare FMP with bonds we will have to take into account the nature of invest and duration.

      If I had to choose bet. just these two, I will choose FMP like you would.

      Reply
  21. Ramamurthy

    Thank you.I have learnt a lot from your Blogs.I eagerly look forward for all your blogs.Unlike others you reply patiently to all the comments.PLEASE continue to educate us.

    Reply
  22. Ramamurthy

    Thank you.I have learnt a lot from your Blogs.I eagerly look forward for all your blogs.Unlike others you reply patiently to all the comments.PLEASE continue to educate us.

    Reply
  23. Prahlad

    Hi,
    I have come in late into this discussion. Appreciate your study. I opted for Taxfree bonds. It has to serve the regular income purpose during my retirement. Im in Gulf and expected either to return home by choice or otherwise in couple of years. Yes I have equity in MFs, FDs in NRE a/cs. But my worry was, after I return to India, interest from FDs etc will be taxed. I had to tr an dreduce tax outgo. Just looked at my annual basic needs and took Taxfree bonds to yield 2 time my annual expenses, as of now. I know, it wont adjust to inflation, that is why I have planned for twice the current need. I expect my equity part to grow and take care of inflation. I may have to shift the excess income from equity to debt to meet increased expenses at a later stage.

    I'm sure there may be chinks in this plan. Just though of sharing with you and see if there is any thing glaringly wrong in my approach.

    Will be happy to have a response.

    Regards,

    Prahlad

    Reply
  24. Prahlad

    Hi,
    I have come in late into this discussion. Appreciate your study. I opted for Taxfree bonds. It has to serve the regular income purpose during my retirement. Im in Gulf and expected either to return home by choice or otherwise in couple of years. Yes I have equity in MFs, FDs in NRE a/cs. But my worry was, after I return to India, interest from FDs etc will be taxed. I had to tr an dreduce tax outgo. Just looked at my annual basic needs and took Taxfree bonds to yield 2 time my annual expenses, as of now. I know, it wont adjust to inflation, that is why I have planned for twice the current need. I expect my equity part to grow and take care of inflation. I may have to shift the excess income from equity to debt to meet increased expenses at a later stage.

    I'm sure there may be chinks in this plan. Just though of sharing with you and see if there is any thing glaringly wrong in my approach.

    Will be happy to have a response.

    Regards,

    Prahlad

    Reply
  25. anubhav

    The writer of the blog makes a passionate plea not to invest in Tax free bonds using so so many logics...i want to ask the blogger if he lives in United states or India.
    there is a reason that most indians invest in Fixed instruments and trust me its not lack of financial knowledge.it is lack of trust in our equity markets and lack of policy consistency by the government. All financial gurus give example of money made in Infosys, wipro and other multi baggers!! boss, please dig into NSE data and tell how many actually bought in 1996 and stayed on till date..lets keep theory in theory and practice in practice..
    India markets are highly manipulated by the selected few and that is the only reason why we have not seen many new rich people ..i have got bored of Rakesh jhunjhunwala givig his gyaan on so many channels..with the kind of buying power he has..he has no right to advise retail investors..
    Coming back to tax free bonds, they are better option than FDs for higher tax bracket people, are extremly safe, give visibility of returns and are also tradeable on the bourses. What else can people want who look at FDs for investment..and mind you..51% people invest in such instruments.
    as a blogger and also as a human being...please understand that there are different segements for each type of products..dont dissuade people from what they feel is right for them.

    Reply

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