Tax Free Bonds

Risk-averse investors now have new options to park their money. The interest earned on these bonds will not be subject to income tax. The interest on these bonds will be paid annually (for example 31st March every year) by credit into the account of the investor. There is no cumulative option.

These bonds will be eventually listed on the Bombay and National Stock Exchange, so investors will have the option of selling them before the full term of the bond. However, the price you may get for selling before they mature will depend on market conditions.

Is effective yield the right way to look at tax-free bonds?
Investors get carried away by the effective yield on tax-free bonds. The effective yield is calculated as follows:

Effective yield = coupon rate/ (1-tax rate). Hence, for a coupon of 8.2%, an investor in the 30.9% tax bracket has an effective yield of 11.86%. The cash flow in the hands of the investor is only Rs 8.2 for every Rs 100 invested in the bonds, and the reason the yield is shown higher is due to the tax rate. Change in tax rate will change the effective yield on the bonds.

Who should invest in tax-free bonds?
Effective yield is only relative in nature, not absolute. If the comparison is between investing in a ten-year fixed deposit of an AAA-rated bank at 8.2% which is taxable and investing in a ten-year maturity tax-free bond at 8.2%, then effective yield can be used as a measure for comparison. Investors can substitute tax-free bonds for fixed deposits as post-tax return is much better on tax-free bonds.

Investors wanting to park surplus funds in an asset that will give them an absolute return of 8.2% every year for ten years, or 8.3% every year for 15 years, irrespective of the returns available elsewhere, can invest in tax-free bonds. In such cases investors are content with the returns offered and have surplus money that can be locked in for ten or 15 years.
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