The Indian government is currently allowing 13 public sector companies to raise funds through tax free bonds. Raising interest rates have made returns from these bonds very attractive. Bonds from rural electrification corporation (REC) is the first hit the market this year. It offers 8.01 and 8.46 percent for the 10 and 15 years options respectively. The later issue namely by the Power Finance Corporation (PFC) offers 8.18 percent and 8.54 percent for the 10 and 15 year tenures respectively. One advantage is that these bonds are listed on the stock exchange to promote liquidity.
However with newer bonds getting listed and offering higher returns the prices of the existing older tax free bonds have fallen in the secondary market. For instance, the 10 year older REC bonds are now quoting at about Rs 962 (face value Rs 1000) in the secondary market. This is a 4 percent discount to its issue price.
Should an investor buy these bonds for their retirement or for current tax free income. We need to go through the following questions before any action should be taken
1. The current bank deposit exceeding 3 years carries an interest of around 9.5 percent. Even after paying the maximum tax rate of 33%, one gets a return of 6.37%. Should you be committing your funds for say 10 years for a difference in yield of less than 2%
2. The Indian interest rates are bound to increase given the increasing rate of budget deficit and accumulating debt. As the interest rate increases the bonds issued already will find their market value dropped sometimes significantly
3. To get the par value for certain one must wait the entire 10 or 15 years
4. Given the inflation scenario, it would be foolhardy to expect that it will come down drastically except if the global economy goes into a recession
5. Political uncertainty in India is bound to increase. We can expect only minority government for a long time to come. Such government will find it hard to take strict measures which may be required to control inflation etc
Here is a set of examples of how the earlier issued tax free bonds are performing
10 Year 15 Year (Face Value 1000 Rs)
Power Finance Corporation 960 Rs 976 Rs
Rural Electrification Corporation 962 Rs 974 Rs
Housing and Urban Development Corporation 963 Rs 970 Rs
Indian Railway Finance Corporation 953 Rs 950 Rs
Indian Infrastructure Finance Company 980 Rs 985 Rs
Finally eventhough these prices are listed the actual price at which these bonds are traded may be much lower. The buyer should be aware of all these limitations before buying these bonds. After all the return from these bonds are just not adequate to accept this level and nature of risk. The word buyer beware (caveat emptor) very much applies here.