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Why tax-free bonds don't excite me?

Public issues of tax-free bonds are eagerly awaited. While many such issues had flooded the market during FY 2011-12 to FY 2013-14, there was a break during FY 2014-15.

Though many PSUs (Public Sector Undertakings) have already lined up their issues of tax-free bonds for the FY 2015-16, I am not too thrilled about it.

Frankly speaking, I don't need to.

Why?

Because there is an excellent alternative viz. the debt mutual funds.

Let me explain how so.

The returns are comparable
Given the general interest scenario currently prevailing in the economy, it is expected that the tax-free bonds to be issued this year would have a coupon rate of around 7-7.5% per annum.

Debt funds, on the other hand, would presently give you around 8-8.5% p.a. returns. This is natural because corporate and other taxable bonds (or even the Govt. Securities i.e. Gilts) typically offer 1 to 1.5% higher yield than tax-free bonds.

I know most of you would react to this by stating... 
a) But income from tax-free bonds is tax free whereas debt funds are taxable
b) But tax-free bonds issued by PSUs have (nearly) zero credit risk whereas private companies do default on their bonds.

While this is theoretically true, practical scenario is quite the opposite.

Let us look at the safety aspect first
Debt mutual funds invest primarily in highly rated bonds only. There is nil or very little exposure to companies with low-rating but high-yields. Besides, they don't restrict themselves to only the corporate bonds. PSU bonds, PSU banks and Gilts too form a fair portion of the total portfolio.

Moreover, the corpus is spread across many companies. Therefore, even if there is trouble with one or two companies, the overall impact on the safety is absolutely insignificant.

Therefore, for all practical purposes, debt mutual funds are almost as safe as the tax-free bonds.

Even the taxation issue is notional
(Note: I will discuss only the Growth Option and not the Dividend Option. Because contrary to popular perception Dividends are not tax-free and hence Growth in most cases is better than Dividend.)

Capital gains from debt mutual funds are taxed as per your slab rate (i.e. zero to 30%) if the holding period is less than 3 years.

For holding period exceeding 3 years, the tax rate is 20% "after indexation benefit". It is this indexation benefit that makes all the difference. 

Given the inflation levels in India, the effective tax that you may have to finally pay on the capital gains from debt mutual funds would drop drastically. It won't be more than single digits, which would be compensated by the extra 1-1.5% returns. In fact, in many cases, it would even be negative i.e. a notional loss, which you can adjust against the actual gains.

By the way, in tax-free bonds, only the interest income is tax free. If you sell before maturity, you will have to pay tax at a fixed rate of 10% on the capital gains WITHOUT any indexation benefit.

So, on tax aspect too, in practical terms debt mutual funds compare quite well with the tax-free bonds... maybe even outshine them.

Now, we come to two other aspects, where debt mutual funds clearly outclass the tax-free bonds.

One is the investment time-frame
Tax-Free bonds normally have a 10 to 20 years duration. Most debt funds (except the Fixed Maturity Plan i.e. FMPs) are open-ended schemes with no time duration or any lock-in. This flexibility has no impact either on the returns or the safety of such schemes, giving the debt mutual funds a clear-cut advantage over tax-free bonds.

The other aspect is the liquidity
Open-ended debt mutual funds can be redeemed and encashed any time.

But, tax-free bonds have no option of premature encashment. Of course, they are listed on the stock exchange and thus can be sold, if need be. But the practical problem is the lack of buyers. Most of the listed bonds are very thinly traded. Thus, you may either not be able to sell at all or forced to sell at a steep discount. Liquidity due to listing is, practically speaking, on paper only.

So now you know why I have a preference for the debt mutual funds vis-a-vis the tax-free bonds.

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