Tax-free bonds: Are you living in the past?

If you are aware of tax-free bonds, you would have most likely invested in the recently concluded offering from Rural Electrification Corporation (REC) and Power Finance Corporation.

Or maybe you did not invest because you were unimpressed with the interest rates offered on these bonds.

After all, REC offered 8.13 per cent on its 10-year tax-free bonds last year compared to 7.72 per cent this year.

But your decision on whether to invest or not in such bonds should not be based on the rates offered in the previous year. Why?

As an alternative to tax-free bonds, you would have most likely invested in bank fixed deposits as it offers higher interest rates.

But you would have to pay tax on the interest income. Assuming you pay a marginal tax rate of 30 per cent, the 7.72 per cent tax-free bonds will be unattractive if bank fixed deposit pays more than 11 per cent pre-tax interest.

Bank deposits do not offer such interest rates at present. Will it offer as much during the next 10 years?

Interest rates

So, why did many of you not invest in tax-free bonds issued so far? As behavioural psychologists state, you were, perhaps, ‘anchored’ to last year’s interest rates.

That is, your decision not to invest in this year’s tax-free bonds was based on the higher interest rate that was offered last year.

Now, what if interest rates actually come down next year? You will most likely have REC and other such companies offering 10-year tax-free bonds at, perhaps, 7-7.25 per cent in 2013-14. If that happens, the current bond offers will look better next year.

And you will most likely pass the 2013-14 tax-free bond issues as well, just like you did with this year’s offerings so far.

Alternate avenues

So, how should you decide on these offers? You should look at alternate investment avenues available today. And as mentioned earlier, unless you expect interest rates to move up sharply, tax-free bond offers could be attractive to you even at the current rates. But consider the associated risk before you decide to buy such bonds.

Tax-free bonds typically pay annual interest, whereas fixed deposits also pay cumulative interest. Now, cumulative option is better.

Because, in the other case, you have to frame rules to ensure that interest income deposited into your bank account every year does not become spending money for that year! You can manage this risk by operating a separate bank account for your investments. Do not use the ATM card on this account. And be sure to have pre-determined rules to use the interest income credited into this account for suitable investments every year.

(The author is the founder of Navera Consulting. Feedback may be sent to >knowledge@thehindu.co.in )

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