When you should and should not invest in tax-free bonds

debt-invest-gettyAshvin is in his early forties and wants to invest in a fixed income product. His investment adviser has told him that quite a few tax-free bond issues are coming up from public sector companies.

Such bonds are long tenor bonds, typically maturing after 10, 15 or 20 years and would make an ideal inclusion in his retirement portfolio.

Every year, interest/coupon will be paid out to Ashvin and it will be tax-free income, while the principal invested will be returned to him on maturity. These bonds will be listed on a stock exchange, offering investors the option to benefit from any appreciation in price and exit before maturity. Ashvin is wondering whether he should invest in such tax-free bonds.

As an investment providing tax-free income, tax-free bonds fare well against bank fixed deposits and debt mutual funds. Ashvin must compute the effective pre-tax interest rate equivalent and compare. The higher his tax bracket, the higher will be the benefit.

In other words, if he falls in the 10% tax bracket, the benefit will not be much. Further, compared to other corporate bonds, these bonds will be highly rated in terms of credit quality. As government of India undertakings, the risk of default is minimal.

However, Ashvin must bear in mind the really long tenor. If he wants to sell it off on the stock exchange when interest rates drop and make handsome capital gains, it may not be possible. Selling such bonds may is difficult for retail investors like himself as these bonds are not frequently traded.

He must accept the possibility that he may be stuck with this investment for its entire tenor of 10, 15 or 20 years. He must, therefore, ensure that he does not have a short-term goal associated with tax-free bonds.

Ashvin should not invest in these tax-free bonds just because the interest is tax-free. He must follow the primary rule of investing – product choice should be driven by his financial goals. Tax-free bonds would be attractive for him if he falls in the higher tax bracket, is looking for regular income and has no concerns on liquidity.