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A Good Bet

Author: Administrator Account/Wednesday, February 24, 2010/Categories: Bonds

A Good Bet

At a time when equity markets are volatile, retail investors have been looking at some safer bets which can deliver good returns. For sometime, debt funds looked like they were doing well, but with RBI taking measures to control rupee, it led to yields going up and debt funds becoming volatile. Since yields are still decently up, fixed maturity plans (FMP) seem to be a good bet.
Now, in this scenario, the question that needs to be asked is whether the tax free bonds which are likely to hit the market almost regularly this financial year, and with Rural Electrification Corporation (REC) and HUDCO already come with the first tranche of their issues, are a good investment option.
Let us first understand what these tax free bonds are.
Tax free bonds are money raising tools used by entities authorized by the central government. This financial year, some 13 companies have been authorised to raise Rs 48000 crore.
These bonds are not a tax saving investment but, the interest earned on these bonds is exempt from tax. So, if somebody is investing in these bonds, he would get an annual interest (or as specified in the issue prospectus) which need not be added back to the income for computation of tax.
Many would feel the interest paid by these is low compared to say, fixed deposits or some NCD issues. But, one has to be aware, that the interest earned on the other instruments will have to be added back to income as income from other sources and would be taxed as per the individual tax bracket.
Further, the rates being offered in here are for a long tenure in the range of 10, 15 and 20 years. Last year, only IIFCL was allowed to issue a 20 year bond, but this year the government has approved all issuing entities to issue bonds for tenure of 10, 15 or 20 years.
For someone concerned with the liquidity and would not be willing to lock in the funds for such long time, have the option of trading them on the exchange where they are listed on both the BSE and NSE.
The investment in these bonds can be done by retail individual investor (RII), high net worth individuals (HNI), qualified institutional buyers (QIB) and corporate entities.
However, the rates offered to the retail investors would be higher than that offered to other category of investors. To be qualified for higher rates, individuals can invest up to Rs 10,00,000. Investing above this limit will see you being grouped into the HNI category, which will lower the interest rates.

What Is The Interest Rate Offered?
The rate of interest offered for various tenures would be linked to government securities of equivalent maturity and shall have a ceiling. The ceiling would be different based on the rating of the issuing company.
The ceiling coupon rate for AAA rated issuers shall be the reference G-sec rate less 55 basis points in case of RIIs and reference G-sec rate less 80 basis points in case of other investor segments. So, retail investors can get 8.04% for 10 years, 8.24% for 15 years and 8.65 for 20 years.
In case the rating of the issuer entity is AA+, the ceiling rate shall be 10 basis points above the ceiling rate for AAA rated entities. In case the rating of the issuer entity is AA or AA-, the ceiling rate shall be 20 basis points above the ceiling rate for AAA rated entities.
 The reference G-sec rate shall be the average of the base yield of G-sec for equivalent maturity reported by Fixed Income Money Market and Derivative Association of India (FIMMDA) on a daily basis (working day) prevailing for two weeks ending on Friday immediately preceding the filing of the final prospectus with the exchange or Registrar of Companies (ROC) in case of public issue and the issue opening date in case of private placement.
 The reason that these bonds are looking very attractive now unlike in the last financial is because the yields of Government Securities has increased considerably since the liquidity tightening measures adopted by RBI.
REC was the first one to come up with the public issue and raked in the amount before the scheduled closing of the issue. HUDCO seems to be going the same way.
 The reason for witnessing such huge volumes is because, 1. The rates are attractive, 2. The companies have government backing, 3. People fear the rates may come down going forward.
 However, investors may invest or wait as there are about 13 companies and the money to be raised is Rs 48000 crore. There will not be a dearth of investment options with regard to tax free bonds in this financial year. The companies authorized by CBDT to issue Tax Free, Secured, Redeemable, Non Convertible Debentures are many. (See In The Queue)

What should one look at before Investing?
►It is advisable to look at the ratings of the companies issuing the bonds. The rating is done by independent rating agencies like CARE, ICRA, CRISIL etc. The companies however being government entities have very low default risk.
►The appetite to hold for a long term. These bonds come with tenure of 10, 15 or 20 years, so one should have the ability to hold them. However, in emergency cases these bonds being listed on exchanges can be liquidated, but it is important to understand that the volumes may not be really huge and one may have to sell them at discount. Also, it is important to note that if sold on the exchange within 12 months, the capital gain, if any, will be taxed as per the individual tax bracket, and if sold after 12 months will be taxed at 10%.
► Read about the company and objects of the issue. This may not be very important considering the rating and backing of government, but still it is always advisable to have a fair idea about the company and where and how the issue proceeds will be utilized.

Who should invest?
As discussed earlier, this investment should not be made plainly because the rates on offer are good; it is imminent to understand the Appetite to hold the funds for long term (although the trading option is available, one should be prepared to hold it till maturity).
These can be a very good investment options for those in higher tax brackets. Let us do a back calculation to arrive at Pre-Tax returns for an individual in various tax brackets to reiterate it. For the calculation we will take the rates being offered by HUDCO which is an ongoing issue (See Mapping Returns). The interest rates look better than even fixed deposits and with comparable safety.

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