Bonds

When you invest in a fixed deposit, the interest you receive is taxed as income. At the highest tax bracket, you pay 30% on that interest. That means a bank FD that gives you 10% really only gives you 7%. Even if you a a longer term investor in the FD, you pay interest every year. (And the bank deducts 10% as TDS before you even see it)

The government has allowed certain entities to give you tax free interest; if you are an investor for the long term, 10 to 15 years, in certain infrastructure companies. Two of them have already issued bonds (PFC and NHAI) and if you missed those, you can subscribe to the next two coming up from Jan 27: HUDCO and IRFC.

* Retail applications are for individuals, for under Rs. 5 lakh, and the higher interest rate is only for the first allotment. Any sale of the security will drop the interest down to the “Others” level.

The bonds will list on the NSE and BSE, and if you can’t get in now, you can buy them off the exchange. (PFC and NHAI bonds will list soon) and the interest will still be tax free. However, in the above two issues, the “coupon” rate paid on the bond will drop, for retail investors.

Since the bond interest is tax free, this is equivalent to a high interest yielding fixed deposit based on the tax bracket you are in. That is, if you had an interest rate of 30% at your highest tax bracket, a coupon rate of 8.35% means an equivalent FD of 12.08%.

But this is a silly comparison. There is no liquidity – of course the bonds are listed but there’s no guarantee that there will be someone willing to buy. Even if there is, the price someone may be willing to pay could be far lesser – in terms of effective yield – than the price you want (An FD can always be returned early with no loss of principal and perhaps a little penalty on the interest) This is like a 15 year FD.

You needn’t invest in an FD to get a similar return, of course. If you’re thinking of exiting in a few years, you may be better off with a longer term FMP, where the post tax returns are around 9-10% nowadays. These mutual funds lock you in similarly, and are listed, but the interest is not taxed till maturity; they tend to yield between 9-11% (this is the rate for long term commercial bonds nowadays) and the fact that you get an indexation benefit will make much of the gain non-taxable.

(A 9% return with inflation at 8% means only the excess 1% is chargeable to tax – even at the highest bracket you’ll make 8.70%)

The comparison, for those who are thinking of this bond as a 1 to 5 year investment, is better off with a similar tenure FMP, or if you choose to be a little creative, with a bond fund.

I strongly believe that we have overcomplicated our options. Thinking in terms of “you can’t compare this with a gilt fund” etc. are simply skirting the issue. People like to think in terms of “debt” versus “equity”, and then long versus short term. FD is debt, as is a bond fund, as is a HUDCO bond. If interest rates fall, a bond fund and the HUDCO bond will increase in market price, but nothing changes with the FD. If you are in for more than five years, and believe that interest rates will fall to below current levels, the HUDCO or IRFC bond is a good idea.

If you’re in for less than five years, consider a longer term FMP or a bond fund instead.

If you’re retired, these bonds are fabulous, because they give you cash flow on which you need to pay no taxes. And for fifteen years!

And finally if you’re a short term investor with the idea that you’ll speculate on these bonds, the trade will clear itself when the PFC/NHAI bonds list either Friday or Monday. Wait to see if there’s a listing gain available.

The short-term government Treasury Bill auctions, conducted every wednesday, have dramatically increased the interest rate that the government is paying for short term borrowing. In the 11,000 cr. auction of the 91 day T-Bills (8,000 cr.) and 364 day T-Bills (3,000 cr.) the cost now beyond 8.1%.

Look at the yield charts over 10 years:

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