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 of course is that there is certainty of income and, of course, safety of capital. But is this the only criteria for making an investment? Our view: not always.

Before we lay out our argument, here are the key assumptions -

• The investor in question falls in the 30% tax bracket (i.e. annual taxable income exceeds Rs 150,000 pa)
   

• The Section 80 L limit available to the individual is exhausted (presently this limit is set at Rs 12,000 pa)

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…

GOI Bonds   Tax Free Taxable Face Value 1,000 1,000 Rate of Interest 6.5% 8.0% Tenure 5 6 Tax on Interest 0.0% 33.0% Net Annual Interest 65 54 Annual Yield 6.5% 5.4%

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% bond, they would want to add back 33% tax they have saved thus taking the return to 8.4% pa (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 a couple of years down the line, don't bank on these bonds to bail you out!

Then of course, 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% and dividend distribution tax has been reduced to 12.5%. So, instead of adding 33% back to the coupon rate, if you were to add even 12.5%, it would give you a pre tax return of just 7.4% pa!

• Real Return Calc

  The point we are making 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?

  Attractive for most…

  5 yr CAGR Post tax CAGR* Schemes Equity Funds 22.7% 21.1% 25 Balanced Funds 21.3% 19.8% 8 Income Funds (LT) 12.1% 11.1% 17 G-Sec Funds 7.5% 6.8% 10 Returns - Compounded Annual Growth Rates * 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.

  If you are in Mumbai and need help in planning your finances, give us a call. We are experienced and qualified and are in a position to meet your requirements. Not in Mumbai? Still want to benefit from our research on mutual funds? Subscribe to FundSelect! Click here to know more.

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