Dheeraj Agrawal
Communication Professional
Risk-averse investors in India trusted fixed deposits whenever they felt insecure about their investments. However, fixed deposits have lost their shine of late because of regularly declining interest rates. Bonds are a good alternative in such cases, but one needs to know how they work before deciding in their favour.
How bonds work?
Let’s start from the beginning and know what bonds are. They are debt instruments that are a means of raising money. And this money is raised by buyers or investors who buy bonds. In simple words, they can be considered as the opposite of loans. When you take a loan, you borrow money from someone, so you become a borrower. When you take a bond, you lend money to someone, so you become a lender.
Governments, companies, municipal corporations all over the world issue bonds for their needs. Each bond unit has a face value or fixed price, and those who buy these bonds are returned that face value after a fixed period. And in this period, its issuing institution gives a fixed interest to its investors at regular intervals, which is called the coupon rate in the bond market language. By the way, such bonds are also issued, in which coupon rate or tenure is not fixed. Such as floating interest bonds, inflation-linked bonds and perpetual bonds. Coupon rates also vary according to market fluctuations in floating interest bonds. The coupon rate in Inflation Linked Bond is intended to beat the inflation rate.
In perpetual bonds, the bond issuing institution does not return face value but pays the bondholder a fixed return for a lifetime. In the case of banks, these perpetual bonds are also called Additional Tier 1 or AT1 bonds. Since they have no maturity date, investors can get their investment back only by selling them in the secondary debt market unless the issuer calls the bonds back, i.e. redeems them. In the past months, AT1 bonds were in the limelight when RBI’s draft restructuring proposal for Yes Bank excluded the AT1 bondholders. The result was that the perpetual bond investors of Yes Bank did face a complete wipe-out of their investments. So remember that when the issuer sinks it is unlikely to redeem the perpetual bonds on its own and for investors, finding buyers becomes near impossible. Perpetual bonds are unlike regular bonds where interest has to be paid regardless of whether the issuer is running a profit or loss. So, there are high chances that no interest payment will be made in case of loss in a year by the issuer.
Naturally, the most popular category amongst all bonds is fixed tenure and fixed coupon rate bond. Please remember that Bonds are generally long-term investment instruments. So whenever the bonds are issued, their tenure can be anything from 5 years to 10 years, 15 years or 20 years. Bonds issued by the government are considered the safest since there is little or no risk of default. The risk of default of any bond can be ascertained by the bond ratings issued by ratings agencies like CRISIL, ICRA, or CARE.
What are tax-free bonds?
In our country, tax-free bonds are issued by government companies or municipal corporations. The interest rate or coupon rate are fixed in this, and its biggest feature is the tax exemption available on it. Remember that the income from the interest of tax-free bonds is tax-free, there is no tax rebate on the investment made in it. Generally, the maturity of tax-free bonds is ten years or more. Government companies or institutions in our country issue tax free bonds only when they have to raise money for infrastructure or housing projects.
Interest income in tax-free bonds is entirely tax-free; also these bonds are kept outside the purview of TDS. And this is a beneficial investment for those who fall in the tax bracket of 20% or more. Since these bonds are issued by the government companies or the government itself, the risk of both capital protection and interest payment is negligible. In terms of liquidity, tax-free bonds lag a bit behind, as they have a more extended maturity period. Although they are traded on the stock exchanges, their volume is very low, and it can be a bit difficult to sell them before maturity.
Difference between tax-free bonds and tax saving bonds
Now one important thing. People are often confused with tax-free bonds and tax saving bonds. But it is very easy to understand. No tax deduction is available on investment in tax-free bonds, but the interest income received is outside the purview of tax. Conversely, once you invest in tax-saving bonds, you get tax deduction once, but there is no tax rebate on the income that you earn. The interest from tax saving bonds is considered your income and will be taxed according to your tax bracket. In our country, infrastructure bonds and capital gains bonds or 54EC bonds come within the ambit of tax savings bonds.
These days, the Floating Rate Savings Bonds of the Government of India is in the 2020 market, in which people can invest. There are two big things to note in this. Firstly, it is a floating rate bond; that is, the interest rate in it will change at regular intervals. At present, the government has kept a coupon rate of 7.15% on it. Secondly, it is a taxable bond, i.e. there is no tax deduction of any kind. Neither on the amount to be invested, nor the interest received. Therefore, these bonds should be bought only from the perspective of investment.
Once again, we turn to tax-free bonds. Many PSUs in our country issue tax-free bonds. These include names like NHAI, i.e. National Highway Authority of India, NTPC Limited, Indian Railways, Housing and Urban Development Corporation, i.e. HUDCO. But since 2016, no government company has issued tax-free bonds. Now you can ask how to invest in bonds when bonds are not being issued. So the answer is through the exchange. I have previously stated that bonds are traded on stock exchanges, so if someone wants to invest in these bonds, then one has an option to buy these bonds from here.
However, before buying these, you have to keep in mind how much return you will get from the bonds. You may think that the returns are fixed in bonds, then what to know. But, here comes the whole game of understanding bonds. In fact, the trading price of bonds may change on a daily basis. And the closer the maturity is, the higher the trading price. This means that even if the face value of a bond is Rs 1000, its trading price can be more than Rs 1000.
We try to explain this with an example. NTPC issued its 10-year bond on 5 October 2015, the face value of which is 1000 rupees. It has a coupon rate of 7.36%. The trading price of this bond, listed on the National Stock Exchange, i.e. NSE, is about 1200 rupees. That is, if you want to invest money in this bond, then you have to pay about 1200 rupees for a unit. And if you keep it till maturity, then every year you will continue to get an interest of 7.36% on face value i.e. Rs 1000. But you have paid 1200 rupees for a bond, so your actual return is 73.60 rupees at 1200 rupees, that is, slightly more than 6 per cent per annum.
6% annual return may look small, but since this return is tax-free and if you are in the tax bracket of 30%, then this return is equivalent to 8.75% return on FD. Even if you are in the 20% tax bracket, it is still equivalent to a 7.6% return on FD. Therefore, buying tax-free bonds from the secondary market can also be a profitable deal from the perspective of return on debt investment.
One more important thing. If you have sold tax-free bonds on the secondary market, i.e. exchanges and you have made any profit on it, then that profit will be taxable. For example, if an investor acquired NTPC’s bonds for Rs. 1000 and sold them at a trading price of Rs. 1200, then he made a profit of Rs. 200 on each bond, and he has to pay capital gains tax on this profit.
Apart from government institutions and companies, private companies also issue large-scale bonds and raise money. But before investing money in any bond, you should check its rating, as well as the credibility and track records of the company issuing it. Investing money in the, is generally recommended to those who do not want to risk too much on their investment and can invest for a longer period. Investing in bonds is considered a good option for portfolio diversification as well.
