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Tax-free bonds or Debt Funds

Last week, one of the blog readers raised the following query...
"Does it make sense to invest in Tax-Free bonds or would the Debt funds be better?"

Let us compare the two on various investment parameters.

a) Returns : Recent issues of Tax-Free bonds are offering around 8.5-8.7% returns per annum. Debt funds are currently delivering returns in the range of 8-10% p.a.

b) Safety : Tax-Free bonds are secured and issued by PSUs. So the default risk is practically zero. Debt funds with high rated investments and diversified portfolio too may practically be free of default risk.

c) Taxation : Tax-Free bonds, as the name suggests, offer tax free returns. Debt funds are taxed nominally at 10% (assuming > 1 year holding period and hence long term capital gains tax of 10% in the growth option). However, it is important to note that only the interest income in Tax-Free bonds is tax free. If sold before maturity, capital gains would be taxable (@10% i.e. same as the debt funds).

Therefore, as far as Returns, Safety and Taxation are concerned, both Tax-Free Bonds and Debt MFs are quite comparable.

The difference lies in time-frame and liquidity. 

While, Tax-Free bonds are of 10 to 20 years duration, debt funds offer a wide range from liquid and ultra-short term funds to FMPs and long term funds. And while, debt funds can be redeemed anytime (except FMPs), Tax-Free bonds cannot be redeemed prematurely. 

Though Tax-Free bonds are listed to provide liquidity, it must be noted that 
a) trading in such bonds is normally thin and hence it may be difficult to find buyers (or you may have to sell at a discount) 
b) like debt funds, prices of Tax-Free bonds too will fluctuate with interest rate movements and hence the possibility of capital loss on premature encashment cannot be ruled out.

Based on the foregoing, one could conclude that normally a Tax-Free Bond would be a good investment ONLY IF someone is willing to lock-in his money for 10-15 years. If not, Debt MFs would be an equally attractive alternative.

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