Tax Free Bonds Vs Debt MF

Devansh Mehta, Senior Investment Advisor, IIFL | Mumbai | September 25, 2017 15:22 IST

Tax free bonds are one such financial instrument that has been in flavour for a long time now. The secondary market has been quite active especially after the stoppage of fresh issuance by the government.

Predominantly investors in India have been risk-averse, who prefer to invest in safe haven instruments like government bonds, bank deposits, tax free bonds and corporate deposits.
 
As of today, market has a plethora of offerings, which are overlooked by investors and they place their hard-earned money in traditional financial tools without proper study.
 
Tax free bonds are one such financial instrument that has been in flavour for a long time now. The secondary market has been quite active especially after the stoppage of fresh issuance by the government. Currently, these bonds are trading at 5.75-5.78% a level, which for a highest tax slab individual comes to 8.92-8.97%. On the surface, it looks lucrative in comparison to various taxable bonds and FDs as these are government backed.
 
But for how long will this lucrative scenario stay?
 
We believe not for long…
 
RBI tries to control the lending and borrowing rates in the economy to control inflation and money supply. We believe there will be a slight downward movement across the yield curve in the coming few quarters.
 
There can be a scenario when interest rate will bottom out and it would be difficult to liquidate bonds and the premium on bonds will start eroding. However, the bonds can be held till maturity as majority of them were issued for 10 to 20 years, but this means that one would get a return of 5.75% till the end of maturity. 
 
Above all the interest is paid out on a yearly basis and the same carries re-investment risk especially in a falling interest rate scenario.
 
What is the alternative?
 
In the current scenario Debt mutual funds is a viable option as against tax free bonds.  
 
The biggest advantage of debt mutual funds is tax efficiency. In addition, these funds are well diversified in terms of credit and interest rate risk as most of the funds have exposures to different tenures and credit quality papers.
 
If invested for 3 years.
Amount (Rs. Lakhs) Tax Free Debt MF Debt MF Debt MF
Date of Investment 01-Aug-17 01-Aug-17 01-Aug-17 01-Aug-17
Amount Invested 100 100 100 100
Holding Period (in Days) 1095 1095 1095 1095
Date of Redemption 31-Jul-20 31-Jul-20 31-Jul-20 31-Jul-20
Returns CAGR % 5.80% 6.50% 7.50% 8.50%
Market Value on Redemption 100 121 124 128
Interest Payout/Gain 17 21 24 28
Assumed Indexation Rate 5% 5% 5%
Indexation Cost 116 116 116
Gain after Indexation 5 8 12
Taxation 1 2 3
Market Value 120 122 125
Net CAGR % Realised 5.80% 6.16% 6.94% 7.73%
The above are indicative returns and not guarantee
 
Debt mutual funds are actively managed by professional experts, who overhaul the composition of the portfolio to suit market outlook which in the long run are bound to offer superior returns. Furthermore, they are easy to exit.
 
We recommend
 
In the current scenario, we can suggest to invest in medium term tenure funds, which would be less volatile in nature and are expected to provide better yields. One should opt for growth option and stay invested for at least 3 years. Post 3 years, debt mutual funds are subject to long term capital gain with indexation benefit.

  CAGR %
Scheme Name Corpus (Cr.) Modified Duration in Years Yield To Maturity 1 Year 3 Years 5 Years
ICICI Pru Long Term Plan(G) 3,134.4 6.4 7.3 10.21 11.94 11.82
Franklin India ST Income Plan(G) 8,704.7 1.8 9.9 10.14 9.53 9.68
HDFC Regular Savings Fund(G) 5,281.9 1.4 8.0 8.17 9.56 9.20
Reliance Corporate Bond Fund(G) 7,401.1 2.9 8.0 8.88 10.27 --
SBI Corporate Bond Fund-Reg(G) 4,430.6 2.0 8.1 8.42 9.99 9.86
Source: ACE MF | The average rolling returns are 3 year rolling return on daily basis for last 5 years. Remaining are P2P returns as on 21st Sept 2017
 
ICICI Pru Long Term Plan (G)
ICICI Pru Long Term Plan is an actively managed dynamic fund which invest across the yield curve to maximise returns. Currently the fund has allocated ~74% of its AUM to G-Secs. Currently, it has allocated ~92% to AAA rated securities, ~8% to AA rated securities.
 
Franklin India ST Income Plan (G)
Franklin India ST Income Plan is a short-term income fund which follows of invest in debt instruments to earn higher yields by investing good quality bonds. Currently, it has allocated ~24% to AAA rated securities, ~32% to AA rated securities and ~44% to A rated securities to generate stable returns.
 
HDFC Regular Savings Fund (G)
HDFC Regular Savings Fund is a short-term income fund which aims to generate long term income through higher accruals. Currently has allocated ~30% to AAA rated securities, ~54% to AA rated securities and ~16% to A rated securities to generate stable returns.
 
Reliance Corporate Bond Fund (G)
Reliance Corporate Bond Fund is a long-term income fund which aims to invest in short to medium term securities to earn accrual from high quality papers. Currently the fund has allocated ~41% to AAA rated securities, ~51% to AA rated securities and ~8% to A rated securities to generate stable returns. 
 

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