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Tax-free Bonds Vs PPF

PPF (Public Provident Fund) has been a favourite among investors since many years. Naturally so. Tax deductions at the time of investment. Tax free earnings during the tenure. No tax on withdrawal at maturity. Competitive yields. 100% Safety. All-in-all a great product.

However, now probably for the first time, PPF has a rival... and a pretty strong one too... called the Tax-free Bond.

So who among them is the winner?

Once again I turn to my 5-Point Formula (that I have used in 'Your Guide to Finance and Investments') to compare the two and determine which product comes out at the top.

Returns: Assuming the investment is held till maturity, returns from tax-free bonds are currently at around 8-8.5%. While PPF rate at present is marginally better at 8.7% p.a., it could vary year after year. 

If the interest rates soften, tax-free bonds will additionally provide capital appreciation and the total returns could even surpass the 10% mark. Whereas PPF rates would be reduced as they are linked to the market rates. Alternatively, if the rates increase, returns from PPF will further improve, but returns from tax-free bonds will remain unchanged (if held till maturity). 

And, one more point, in PPF there is automatic compounding. In tax-free bonds you will receive the interest, which you would have to invest. Else you will lose the benefit of compounding.

Given that the rates are probably at near peak levels and could head south in the future, tax-free bonds presently enjoy maybe a slight advantage over PPF.

Time Frame: PPF has a 15-year tenure. Tax-free bonds are typically available for 10, 15 or 20 years (which would actually be lower depending the bond you buy from the market).

Ok. So nothing much to distinguish between two on this aspect.
Liquidity: Tax-free bonds are listed on the stock exchange. So theoritically, you can sell any time you want to. But there could a problem. Maybe there are no buyers. Or the buyers are asking for a steep discount. PPF, on the other hand, permits loan from 3rd year onward and withdrawal from 7th year onward.

However, while entire investment can be sold in case of tax-free bonds, PPF withdrawals are limited.  

Given that both investments are made with long-term objective in mind, I guess PPF has a slight edge here.

Risk: PPF is a Govt. of India scheme. So that's 100% safe. Tax-free bonds are issued by companies. But these are predominantly public sector companies. I don't think any Govt. would allow PSUs to default. Moreover, these are secured by the assets of the company. So tax-free bonds too can be considered to be almost 100% safe. 

So let's say, again they are almost at par as far as safety is concerned. 

Taxation: Both give tax-free interest. Though PPF also gives tax benefit u/s 80C, there are many alternatives available. So even if one chooses tax-free bonds, the gap under 80C can be filled by some other product.

If sold before maturity, capital gains if any in tax-free bonds would be taxable. However, interim withdrawals in PPF carry no tax.

Here, one could say that the advantage lies with the PPF.

FINAL VERDICT: There is very little to choose between the two. Depending on which parameter is critical for you, you can make your choice.

In fact, given that PPF has an investment limit of Rs.1 lakh, one could possibly first exhaust this limit and invest the surplus thereafter in tax-free bonds, to enjoy the best of both the worlds.

In short: Heads you Win. Tails you Win.

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