NHAI & PFC have launched their tax free bonds, which would close for subscription on 16^th Jan 2012. But looking at investors craze, it is expected that they will close earlier. Some other PSUs are in the queue with their offerings including HUDCO &India Railway Finance Corporation.

I have already shared 2 articles on the tax free bonds:

NHAI & PFC Tax Free Bonds

Can NRIs invest in tax free bonds?

Mails poured in with the subject “Should I invest in Tax Free Bonds?” and I replied with my favorite answer “DEPENDS”. But looking at the number of question, I have decided to share my view points.

They say “If you torture numbers enough, they will confess to almost anything” – so I will not torture numbers but will just ask three simple questions.

1. Are tax free bonds risk free?

For most of the people definition of risk is capital loss. So, in that case I believe there is not much risk as these are secured bonds from Public Sector Units. Even credit agencies like ICRA & Care have given their highest rating to NHAI & PFC issues. But what about other debt related risks:

Interest Rate Risk:There is negative relation between price of bond & interest rates – if interest rate will increase price of bond will go down & vice versa. This risk can be reduced if you hold bonds till maturity.

Liquidity Risk: Only way of exit from these bonds before maturity is selling them through stock exchange. If you have some bonds that you would like to sell for immediate requirement but there is no buyer or fewer buyers than sellers – you may have to sell your bonds at discount.

Reinvestment Risk: This is the biggest risk in these bonds. Prima facie it looks that these bonds are giving tax free 8.2% (10 year bonds) interest rate which should be equivalent to 11.87% taxable returns for someone who is in highest tax bracket. But important point her is these bonds are paying interest annually & not on cumulative basis – so you have to invest your coupons in some other investment at that point of time. Now this second instrument can be tax free or taxable with higher or lower interest rate. So reinvestment risk can have a major impact on your final yields.

2. Are tax free bonds better than SBI 10 year FD?

Every investment product should be compared with some similar product which can also have equal chances to be part of your portfolio. Here we are trying to compare SBI 10 year term deposit with PFC 10 year tax free bonds.

But first question is can we compare them at all? Not 100% as both the products have different features & risk. But still they can be compared if we assume that we are talking about a long term investor who will hold this product till maturity and SBI FD is as safe as these bonds.

SBI is giving 9.25% quarterly compounding on 10 year term deposits. If we convert quarterly compounding to yearly compounding, it turns to 9.58%. Now, I have Rs 2 lakh that I can invest for 10 years & I am in highest tax bracket. I distribute my money equally in Bank FD & PFC Tax Free Bonds.

My bank FD will mature with amount of Rs 249639 – assuming, no TDS was deducted. (TDS is part of overall tax so it will not make much difference in rupee terms) After paying 30.09% tax on the interest part I will receive Rs 203401 So my tax free CAGR (compounded annualized growth rate) on bank FD will be 7.36%. {Check Table A}

Now on other hand my investment in PFC tax free bond gives annual interest of Rs 8200 (on Rs 1 Lakh). As I am long term investor, I don’t want to use this amount and would like to reinvest it. I may or may not get tax free options or even lower interest rates in future. So assuming that I will invest interest amount in some other instrument which can give me taxable return 8.2% CAGR till the maturity date of my 10 year PFC tax free bonds. So in case of PFC tax free bonds my final maturity will be Rs 208168 means a tax free CAGR of 7.61%.

So there is just a difference of .25% in highest bracket and is just opposite in case of Lower tax slabs. {Check Table B}

3. Are tax free bonds for wealth creation?

This is the last question but most important. Everyone should know purpose of his investment & if your purpose of investment is wealth creation, answer to above question is NO. Tax free bonds are for capital protection in best case scenario – in high inflation scenario even they will not be able to beat inflation. Tool for wealth creation is equity & according to current tax laws there is no long term capital gain tax on equity as well. For me it is really hard to think that equities will give less than 8.2% return in 10 years and 8.3% return in 15 years. Have we forgotten the basic rule – equity for long term & debt for short term.

So, does that mean one should not invest in these bonds? My answer is “it DEPENDS on your personal financial situation”. Do all permutation combination with your financial life and then take a cool headed final decision. Think Twice – Act Once.

I will love to hear your views in the comment section.

With Season’s Greetings the season for Tax Free Bonds has also started with announcements from NHAI (National Highway Authority of India) & PFC (Power Finance Corporation of India) – both companies are opening there issues on 28^th December 2011. But this is just a starting as you will also see other PSUs lining up there tax free bonds including HUDCO & Indian Railway Finance Corporation.

If I am not wrong in 2003 RBI was offering tax free bonds in name of RBI Relief Bonds – last rate was 6.5% tax free. HNIs were crazy about these bonds & now queue will be long as current bonds have limits. These bonds are tax free, secured, redeemable & non convertible.

Interest Rates on NHAI & PFC tax free bonds

According to guidelines, coupon rates on tax-free bonds should not be more than G Sec yield less 50 bps for bonds issue through public issue. So NHAI & PFC both opened full throttle – 8.2% for 10 year bonds & 8.3% for 15 year bonds. Interest is payable annually. {PFC Bond information is based on Business Bhaskar}

Effective yields in NHAI & PFC bonds

Note for Future Issues: As rates on these bonds depend on G Sec yields – you may expect a lower or higher rate depending on G Sec future Yields. If these bonds were launched in November 2011 – highest possible yields were 8.43% & 8.53% as G sec yields were close to 9% at that time.

What Tax Free means?

• The income by way of interest on these Bonds is fully exempt from Income Tax and shall not form part of Total Income.
• There will be no deduction of tax at source (TDS) from the interest, which accrues to the bondholders in these bonds irrespective of the amount of interest or the status of the investors.
• Wealth tax will not be applicable on these bonds.

Note: If you redeem these bonds through exchange before maturity – there can be capital gain tax or capital loss depending on your sale price.

Changes in tax benefits after DTC

Hopefully the above mentioned tax benefits will continue but would like to add a point which is mentioned in both prospectuses.

The Hon‘ble Finance Minister has presented the Direct Tax Code Bill, 2010 (DTC Bill‘) on August 30, 2010, which is proposed to be effective from April 1, 2012. The DTC Bill is likely to be presented before the Indian Parliament thereafter. Accordingly, it is currently unclear what effect the Direct Tax Code would have on the investors.

Tax Free bonds issue dates

• Opening – Both the bonds will open on 28^th Dec 2011
• Closing – NHAI will close on 11^th Jan 2012 & PFC on 16^th Jan 2012

In both the case issues can be closed earlier (minimum 3 days).

Allotment Basis of tax free bonds

In NHAI bonds it is first come first serve basis for HNI & institutions but for retail it is on pro-rata basis. In PFC bonds allotment is on basis of first come first serve basis but last days applications will be treated as equal – bonds will be based on pro-rata basis. These bonds can be applied in both demat & physical form.

Credit Rating

Both NHAI & PFC Bond issues have got highest credit rating from ICRA & Care – that is AAA.

Issue Size

• NHAI Bonds – Rs 5000 Crores with option to retain oversubscription upto Rs 10000 Crores
• PFC Bonds – Rs 4033 Crores

30% of the base issue size is kept for retail clients. (Where application size is less than Rs 5 Lakh)

Minimum Application Size

In case of retail investors it is Rs 50000 & thereafter in multiples of Rs 1000.

Tax Free Bonds – Frequently Asked Questions

These FAQs are taken from RR Finance – who is lead manager in PFC issue. I have made some changes based my glance through prospectus of NHAI & PFC.

Where the bonds would be traded?  Whether in BSE and NSE or WDM?

NHAI bonds are proposed to be listed on both BSE and NSE. The trading can happen only in Demat form. PFC bonds will be listed on BSE only.

Who Can Apply

• Individuals and HUFs
• NRIs (both on repatriable & non-repatriable basis)
• Corporate
• FIIs
• Financial Institutions, Mutual Funds, Pension funds,
• Partnership firms & Limited liability partnerships
• Insurance Companies

Is the coupon fixed through-out the tenure?

Yes, the coupon will be constant and will be paid annually during the full tenure of 10/15 years.

Is there a lock in period in the issue?

The issuer will redeem the bonds only at the maturity and there are no buy back options. The investor however need not hold the bonds for any minimum tenure to avail the tax benefit. The bonds can be purchased or sold on exchanges any time at the prevailing prices.

What will be the tenure of the Bonds?

Choice of 10 years and 15 years will be there

Is Demat account Mandatory to invest in tax free bonds?

The bonds can be allotted either in Demat or Physical form. However, they can be traded in exchange only in Demat mode.

Will TDS be deducted from the interest payment?

Bonds are Tax free and not subject to TDS

Will there be the interest on application money?

Yes.  The interest will be decided by the issuer at a later date. Usually it is equivalent to the coupon but it depends from issuer to issuer

Will two applications from a single investor be accepted?

Multiple applications are allowed

Whether PAN Card is mandatory? What if the applicant, who is an assessee holds, only a letter from the IT Department (procedure in olden days) indicating the PAN?

The investor must have a PAN to apply for these bonds.

In case of application for securities in demat form, no PAN copy has to be attached. A self attested copy of PAN card of the investor is required to be attached to form when bonds are applied in physical form.

Is the interest on these bonds paid out periodically or is there a compounding option in the bonds?

The interest on these bonds will be paid annually (for example 31^st March every year) by credit into the account of the investor. There is no cumulative option.

What is the tax treatment of different flows from the bonds?

Please note that the sum invested in these bonds is not eligible for any deduction under section 80C, 80CCF or 54EC. The interest on these bonds is tax free. Thus no income tax would be required to be paid, nor will it be subject to TDS. However, capital gains on these bonds are taxable like normal corporate bonds.

If the bonds are sold within one year of the date of purchase, the short term capital gains arising would be subject to tax at slab rates. For sale after a holding period of one year, the long term capital gains will be taxable at 10% without any indexation benefit.

Whether the capital gains, if any, could be re-invested in any other instrument for avoidance of such tax?

Any capital gains arising on sale of assets can be set off by investment in eligible assets as the prevailing rules of the government.

Whether investments can be made by individuals jointly on “Either or Survivor” or “Anyone or Survivor” basis?

The application on bonds can be made on single or joint basis. Where two or more persons are holders of any Bond (s), they shall be deemed to hold the same as joint holders with benefits of survivorship subject to applicable laws. Where Bonds are held in joint names and one of the joint holders dies, the survivor(s) will be recognized as the Bondholder(s) in accordance with the applicable laws.

Whether an applicant applying in the first day of opening of the issue is assured of allotment? This is a very important question, especially from the HNIs.

The issue will remain open for at least 3 days. If the issue is over subscribed within this period, the applicants will receive allotment on pro rata basis. Thus investors who have applied during this period will receive at least some allotment. If issue extends beyond 3 days, the applicant in first 3 days will receive full allotment.

Disclaimer: I can’t take any guarantee that above mentioned information is 100% correct. Read the prospectus before investing in these bonds.

If you have any questions regarding these bonds – feel free to ask.