Tax-free bonds: Not just a tax shelter

Oct 04 2013, 17:59 IST
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For investors in the highest tax bracket, the effective yield is high. (IE Photo) For investors in the highest tax bracket, the effective yield is high. (IE Photo)
SummaryFor risk-averse retail investors, tax-free bonds of PSUs provide an opportunity to earn good returns.

degree of safety regarding timely servicing of financial obligations. Similarly, Brickwork Rating has assigned a credit rating of AAA; Credit Analysis & Research has given a credit rating of AAA to the bonds.

Non-convertible debentures

For retail investors, some non-banking finance companies are launching non-convertible debentures (NCDs) with higher interest rates. However, financial planners say higher rates should not be the only reason to lap up NCDs.

Instead, before investing, investors must look at the company's past lending performance, cash flows and business risk to ensure that it does not default on payments after maturity. Financial planners also say that while it is always prudent to allocate some part of one’s portfolio to NCDs, the investment should not be over 20% of the total portfolio because of the risk involved. Also, NCDs are not as liquid as bank fixed deposits as the secondary market for corporate bond is not that well developed. Without a vibrant secondary market for these bonds, an investor may have to sell the NCDs at a discount and NCDs can never be converted into equity or preference shares. After maturity or redemption, the company gets back its debenture and the debenture holder gets back the principal invested, along with the interest accrued.

NCDs can be both secured and non-secured. All secured NCDs are backed by assets and if the company defaults, the secured assets are then liquidated to repay NCD investors. With unsecured NCDs, companies offer a much higher rate as there are no assets that can be liquidated in case of default. If NCDs are sold on the stock exchange within 12 months of the date of allotment, an investor will have to pay short-term capital gains tax. Beyond one year, it will be treated as long-term gain.

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