Bank Fixed Deposits (FDs) provide an easy and safe way to invest your money, but due to tax and inflation inefficiency they actually give much lower effective return than the rate of interest that the deposits offer. The interest rate offered by banks on FDs are generally marginally higher than the prevailing inflation rate and after deducting taxes, the actual return becomes lower than the rate of inflation. As a result FD investments suffer capital erosion in long run as the long-term maturity values fail to keep the purchasing power of the money invested intact at the time of maturity.
On the other hand, investors need not pay any tax on return generated from the investments made in tax-free bonds, so the effective return is same as the coupon rate offered by the bonds. With the coupon rates also vary with the rate of inflation, the investors generally end up with maturity value of higher purchasing power or the purchasing power of the money remain intact at the end of the investment period.
Moreover, the investors may make some capital gain as well by selling the bonds in secondary markets, in case the value of the bonds appreciated before the maturity period. On the other hand, an FD investor wouldn’t get any such chance as, unlike bonds. FDs are not traded in secondary market and by premature withdrawal, FD investors may lose some interest.
However, due to lack of knowledge, people generally avoid tax-free bonds and want to stick to bank FDs only. There are also misconceptions about the tax-free bonds and people get confused with tax-free bonds and other tax-saving instruments.
"Often, investors mistake these tax-free bonds for tax saving infrastructure bonds. However, with tax-free bonds investors cannot expect any kind of tax exemption. ‘Tax-free bonds’ are named thus since investors are not required to pay any tax on the interest income accrued," says Ankit Agarwal, Managing Director, Alankit Limited.
Agarwal also explains the features, benefits and safety of investments in tax-free bonds in details.
Higher effective after-tax returns: Tax-Free bonds are tax efficient as compared to the bank FDs.
Scope of capital appreciation: India has been facing high inflation rate with the interest rates also going on the higher side. It is likely that RBI might cut interest rates. Bond prices tend to rise whenever the interest rates fall. In a scenario like that, there is no scope for FDs to result in any capital appreciation as FDs are not tradable and one cannot transfer the ownership of their FDs to anyone else in the market. Therefore, there are chances of capital appreciation with tax- free bonds as and when the inflation and interest rates drop.
Safety: Backed by physical assets, the bonds are secured in nature. In an unlikely event that a company goes bankrupt and its assets get liquidated, then the bond holders are the ones who stand first in the pecking order. On the contrary, FDs are unsecured and not backed by assets.
Liquidity: Another striking feature of tax-free bonds is their liquidity. Bonds are tradable on exchanges and thus more liquid. However, when FD is broken prematurely, the bank either charges a premature withdrawal penalty or gives the applicable rate of interest for the period one holds the FD.
Returns: Bonds provide an additional scope of earning capital gains, as Bond prices fluctuate either on the basis of fluctuating market interest rates, changes in the creditworthiness of the issuer, or both. FDs are not tradable on an exchange, and therefore they do not provide the scope of earning capital gains.
TDS on FDs: Another negative factor about FDs is that they allow the banks to deduct tax whenever they pay you an interest exceeding Rs 10,000 per year (exceeding Rs 50,000 for senior citizens and for other investors, the limit will be increased to Rs 40,000), whereas tax-free bonds attract no tax and thus no scope of any TDS.
Taxation: Interest from both Bonds and FDs is subject to income tax as per an individual's tax slab. Yet, there are tax-free bonds issued by the government, on whose interest no income tax is payable. If an individual decides to sell his or her bonds on an exchange prior to maturity, capital gains are applicable.
Benefit for HNI Clients: Tax-Free bond issues might not be able to match its past performance, but with RBI slashing interest rates, they are expected to bring sound returns. Moreover, these instruments deliver profitable investment opportunity for investors in the higher tax brackets (30 per cent and 20 per cent) or high-net worth individuals (HNIs).
So, there is no harm in allocating some money to tax-free bonds to enjoy its benefits and gain confidence to reduce dependency on inefficient bank FDs.