Ask any investor where he/she invests most of his/her money and the answer will probably include Relief Bonds (now known as the tax-free and taxable GOI Bonds).
And what about the allocation to Relief Bonds? Well, that would invariably be disproportionately high. The argument is that there is certainty of income and, of course, safety of capital.
But is this the only criterion for making an investment? Well, not always.
Before we lay out our argument, here are the key assumptions:
Now, let's take a look at the table below, which gives details of the two types of GOI Bonds available in the market today.
| Unattractive for most. . . | ||||||||||||||||||||||||
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A lot of investors will want to look at these rates of interest on a pre-tax basis i.e. in case of the 6.5 per cent bond, they would want to add back 33 per cent tax they have saved thus taking the return to 8.4 per cent p.a. (as some would say, what's saved is earned but let's revisit that later in this article).
Now, for a tax-free bond, this is a good return. The return on a taxable bond, of course, remains unchanged.
Does the tax free bond make investment sense then? Sure, it does. But going overboard in this one investment product would not be a wise thing to do.
What are the reasons, other than safety of capital and surety of income for investing in such bonds?
One, of course, is that if you are looking for a very low risk investment opportunity for a tenure that matches that of a tax free bond, you may wish to go in for the same. There is no better product out there that fits this criteria.
Two, you may wish to consider these bonds as being part of a portfolio which is designed to beat inflation (so there is no 'real' erosion in value of money) but primarily aimed at providing a long term security net for your family.
Something you should know about these bonds
Since the new series of these bonds was issued, it is no longer transferable and cannot be used as collateral (this used to be a big advantage as one could capitalise on falling interest rates). So if you are well-to-do today, but are in need of funds
Also the returns on these bonds are not as attractive as it is made out to be. Adding back the income tax saved is one way to look returns, but then one must look at the tax rates applicable to income from other investment products long-term capital gains tax is just 10 per cent and dividend distribution tax has been reduced to 12.5 per cent. So, instead of adding 33 per cent back to the coupon rate, if you were to add even 12.5 per cent, it would give you a pre-tax return of just 7.4 per cent p.a!
The point is that there is a place for the tax-free bond in every portfolio. But, the allocation to the same must be in line with your risk profile and needs. For example, if you can take moderate risk and are looking to invest for say 10 years, this bond is surely not the product for you.
What are the alternatives?
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* Avg of all schemes (save for equity) with 5 yr record taken. Tax assumed - 10% capital gains tax (no indexation benefit) |
The alternatives are abundant. We recommend that individuals should opt for mutual funds to meet most of their needs (please note that the returns stated in the table alongside are historical and future returns could be very different). Again, this is not to say that one must invest only in mutual funds.
Investors must work on their asset allocation and invest accordingly. In asset classes where they do not have expertise, they should consider option for professional management, something that is offered by mutual funds.