Fixed Deposits v/s Tax-Free Bonds

I have been investing in debt funds for the past few years. Recently, I have noticed that several tax-free bonds have been launched. Should I invest in these bonds or in fixed deposits? I pay tax at 30 per cent.

- Shivam Rupani

In the current scenario, you may be better off investing in tax-free bonds rather than in fixed deposits, as the former have the potential to generate higher returns and are, as their name suggests, more tax-efficient. Unlike tax-free bonds, investments in fixed deposits are taxable. Currently, most major banks offer 10-year fixed deposits with rates between eight and nine per cent p.a. As your tax slab is 30 per cent, your post-tax returns from a 10-year fixed deposit will only be around six per cent p.a., as shown in the chart.

Over the past few weeks, several PSUs have launched tax-free bonds with significantly higher interest rates than the comparable bank fixed deposits.

As shown in the graph, even the lowest interest rate (offered by IIFCL) surpasses the post-tax yield of 10-year fixed deposits! For investors in the highest tax brackets, 10-year tax-free bonds effectively offer pre-tax rates of around 12 per cent p.a. Most major banks do not have fixed deposits which match this rate before tax.

Most tax-free bonds have low credit risks as they are issued by PSUs, which are backed by the government. Hence, these bonds are almost as safe as fixed deposits, although investments in fixed deposits are protected against default to some extent. In case of a bank failure, the government’s deposit insurance scheme will cover Rs 1 lakh of your deposit. However, there is no guarantee about the remainder. Investments in tax-free bonds are not guaranteed, but the bonds currently available have high credit ratings (AA+ and AAA). According to CRISIL, instruments rated AAA are considered to have the highest degree of safety regarding timely servicing of financial obligations and those rated AA also enjoy a high degree of safety.

Details of the tax-free bonds that are currently available are shown in the table below. These bonds have been very popular, with some issues being oversubscribed. The highest yield is offered by HUDCO, as it has a slightly lower credit rating than the others.

Note: Yields refer to those for ‘Category IV’ investors – these are retail investors who invest a minimum of Rs 5000 and a maximum of Rs 10 lakh in these bonds. Interest rates for these investors will be 25 basis points higher than those offered to HNIs and institutional investors.

Additionally, you may benefit from capital appreciation by investing in tax-free bonds. The prices of tax-free bonds may rise if the interest rates fall. You can then sell these bonds in the secondary market for a profit. Fixed deposits do not offer any such upside potential. Of course, this also means that you may suffer a loss if interest rates rise. The near-term outlook for interest rates is uncertain, but interest rates are likely to fall in the medium-long term because of the severity of the economic slowdown. Note that interest rate movements will not affect you if you choose to hold the bonds till maturity, as the effective return on your investment will be the same as the offered yield.

Furthermore, tax-free bonds allow you to invest your money for as long as 20 years. In contrast, most fixed deposits only have a maximum tenure of 10 years, after which you will have to invest in a new fixed deposit. Also, you can redeem your investments in tax free-bonds before maturity without incurring any penalties by selling them in the secondary market. If you choose to break your fixed deposit before the stated maturity date, you may have to pay a penalty.

In the current economic scenario, tax-free bonds offer several advantages over fixed deposits of comparable maturities. However, if you want to sell your bonds before maturity, remember that the secondary market may be illiquid, especially for small-ticket transactions. Furthermore, capital gains made on the sale of tax-free bonds in the secondary market are taxable. In addition, you may need a demat account.