Relief Bonds: Avoid or own?

Ask any investor where he/she invests most of his/her money and the answer will probably include Relief Bonds (now known as the tax-free and taxable GOI Bonds).

And what about the allocation to Relief Bonds? Well, that would invariably be disproportionately high. The argument is that there is certainty of income and, of course, safety of capital.

But is this the only criterion for making an investment? Well, not always.

Before we lay out our argument, here are the key assumptions:

• The investor in question falls in the 30% tax bracket (i.e. annual taxable income exceeds Rs 150,000 pa)
• The Section 80 L limit available to the individual is exhausted (presently this limit is set at Rs 12,000 pa)

Now, let's take a look at the table below, which gives details of the two types of GOI Bonds available in the market today.

A lot of investors will want to look at these rates of interest on a pre-tax basis i.e. in case of the 6.5 per cent bond, they would want to add back 33 per cent tax they have saved thus taking the return to 8.4 per cent p.a. (as some would say, what's saved is earned but let's revisit that later in this article).

Now, for a tax-free bond, this is a good return. The return on a taxable bond, of course, remains unchanged.

Does the tax free bond make investment sense then? Sure, it does. But going overboard in this one investment product would not be a wise thing to do.

What are the reasons, other than safety of capital and surety of income for investing in such bonds?

One, of course, is that if you are looking for a very low risk investment opportunity for a tenure that matches that of a tax free bond, you may wish to go in for the same. There is no better product out there that fits this criteria.

Two, you may wish to consider these bonds as being part of a portfolio which is designed to beat inflation (so there is no 'real' erosion in value of money) but primarily aimed at providing a long term security net for your family.

Something you should know about these bonds

Since the new series of these bonds was issued, it is no longer transferable and cannot be used as collateral (this used to be a big advantage as one could capitalise on falling interest rates). So if you are well-to-do today, but are in need of funds a couple of years down the line, don't bank on these bonds to bail you out!

Also the returns on these bonds are not as attractive as it is made out to be. Adding back the income tax saved is one way to look returns, but then one must look at the tax rates applicable to income from other investment products – long-term capital gains tax is just 10 per cent and dividend distribution tax has been reduced to 12.5 per cent. So, instead of adding 33 per cent back to the coupon rate, if you were to add even 12.5 per cent, it would give you a pre-tax return of just 7.4 per cent p.a!