Tax-free bonds are bonds which pay tax-free annual interest. We discussed how to invest in such bonds in this column dated September 8, 2013. The question is: Should retirees invest in tax-free bonds? The question is important for two reasons. One, tax-free bonds are attractive for those paying 30 per cent tax.

Two, you need monthly cash flow; tax-free bonds pay annual interest. In this article, we discuss how, despite these issues, you can use tax-free bonds in your retirement income portfolio.

cash flow Suppose you retire at 60 and have a 30-year life expectancy. How should you use tax-free bonds that are typically offered in three maturities: 10, 15 and 20 years?

One, choose the longest maturity bond (20 years). Why not use the breakeven rule (that we discussed in this column dated September 8) to choose the bond maturity? Based on the breakeven rule, you may decide to buy the 15-year tax-free bond, for instance. But your investment horizon is 30 years. You, therefore, have to reinvest the proceeds at maturity for another 15 years. If you invest in a 20-year bond, you have to reinvest the proceeds for 10 years.

The point is this: If tax-free bonds are not available in the future, it may be difficult for you to find a 15-year tax-free bond or even a 15-year taxable bank deposit. It is relatively easy to find a 10-year investment. Importantly, more number of times you reinvest, higher your reinvestment risk.

Two, you have to calculate the amount to be invested in the bond. The investment amount should be such that the annual interest covers your annual living expenses between 79 and 80. During the 20 years between 60 and 80, the highest amount that you will require for spending is during 79-80, because price levels rise every year.

So, if you intend to spend Rs 50,000 each month based on current prices (Rs 6 lakh per annum), the amount required during 79-80 assuming 8 per cent annual inflation is nearly Rs 26 lakh. At 8.66 per cent coupon rate , you need to invest Rs 3 crore at age 60 in a 20-year bond. You may want to spread the amount across various bond issuers.

Three, based on your investment above, you will have more money than you require every year between 61 and 79. You should save the excess amount in a taxable bank fixed deposit or in an equity index fund. You can use this amount during times when inflation is higher than what you have assumed and/or if you need to spend more money than you have budgeted for in any year.

spending requirement Four, we have assumed that you will take your monthly spending requirement in advance every year. That is, at 79, you will have the total money required for all months between 79 and 80. You can invest this money and earn interest till you actually withdraw it. Suppose the 20-year tax-free bond pays you interest in January. After keeping aside money needed for your living expenses for January, you can invest in one-month deposit which matures on February 1, two-month deposit which matures on March 1 and so on till December.

Picture a ladder where each rung is your fixed deposit maturity; the deposit amount corresponds with the money you require for that month.

You can invest in tax-free bonds to fund your living expenses if you are a tax-paying mass-affluent retiree. The process suggested above, though somewhat cumbersome, is practical and can be self-managed. You can alternatively buy these bonds for your stock-bond-annuity portfolio as a partial substitute for bank fixed deposits.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in )

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