High-tax bracket investors should go for REC bonds :: Business Line

�� -->

Interest income on these bonds is tax free, hence returns are higher than the after-tax returns on bank fixed deposits for investors in the 30 per cent tax bracket.

Power sector lender Rural Electrification Corporation (REC) has kick-started the tax-free bond season this fiscal for the public. Rates for retail investors are 0.5 per cent higher than rates for other investors. Retail investors in the higher tax brackets can consider investing.

BETTER RETURNS, LOW RISK

Interest income on these bonds being tax-free, the returns are higher than the after-tax returns on bank fixed deposits for investors in the 30 per cent tax bracket. Currently, the highest rate on bank deposits is 9.5 per cent. Compounded quarterly, the pre-tax annual return works out to 9.84 per cent.

For an investor in the 30 per cent tax slab, the after-tax return is 6.8 per cent, lower than what the REC tax-free bonds offer. But for an investor in the 20 per cent tax bracket, the after-tax return works out to 7.82 per cent. This is higher than the REC 10-year bond (7.72 per cent), but lower than the 15-year bond return (7.88 per cent).

While bank depositors’ money is insured up to Rs 1 lakh in each bank, REC’s tax-free bonds are secured, have the government’s support, and the highest credit ratings, making the whole investment safe.

So, even retail investors in the 20 per cent tax slab can consider sacrificing a little return for more safety and invest in the bonds. Also, with a possible increase in their income, investors in the 20 per cent tax slab now may move to the 30 per cent bracket in the future. Given the long tenure of the REC bonds, such investors can consider investing in these bonds. While non-resident Indians (NRIs) are eligible for investing in the bonds, they would be better off investing in NRE fixed deposits with banks which offer rates of around 9 per cent, tax-free.

PRIORITISE TAX-DEDUCTIBLES

Before investing in the REC issue, investors should set aside funds for investing in avenues such as public provident fund (PPF) and national savings certificate (NSC) which offer tax deduction up to Rs 1 lakh. To begin with, PPF gives better regular returns (currently 8.8 per cent tax-free) than the REC bonds. Also, tax deduction on PPF investment increases the effective return, a benefit not available on REC’s bonds.

But PPF has investment amount restriction (Rs 1 lakh annually), relative illiquidity, no regular interest payouts, and market-linked rates. REC bonds have higher investment limits, can be sold easily, and annual interest payouts at the same rate until maturity. An investor’s debt portfolio should ideally have place for both tax-deductible and tax-free options.

SHOULD YOU WAIT?

No. There is a good possibility that the Reserve Bank of India, to prop up economic growth, may cut interest rates in the near future. This could result in government bond yields declining and forthcoming tax-free issues offering lower returns than REC. So, investors may be better off locking into this issue.

RE-INVESTMENT RISK

Annual interest payout in REC bonds works well for investors who need the cash. But those without this need may face re-investment risk – the risk of having to invest the receipts at a lower rate in the future. Such investors can consider deploying their annual interest income in avenues such as PPF, NSC and cumulative bank deposits (after assessing after-tax returns).

REC bonds can be traded in the market. But note that gains made on selling the bonds will be subject to capital gains tax. Further, those who buy or acquire the bonds from retail investors will not get the additional rate benefit of 0.5 per cent being offered to retail investors during the issue.

COMPANY DETAILS

REC finances rural electrification projects in India. The company’s outstanding loan book of Rs 1,11,965 crore as on September 30 is led by the transmission and distribution segment, followed by power generation.

More than 80 per cent of its exposure is to state electricity boards (SEBs), many of which are in financial difficulty. Despite this, REC has consistently posted good results. Between 2008 and 2012, its loan disbursement grew at an annual growth rate of 17 per cent while profit grew 34.5 per cent annually to Rs 2,817 crore.

In the first half of the current fiscal, REC’s loan disbursements grew 25 per cent and profit increased 42 per cent. The company’s interest spread was a healthy 3.57 per cent.

Strong backing from the Government and the secured nature of much of its loan book lend comfort. The company’s net non-performing asset ratio as on September 30 was low at 0.38 per cent. The company has a credit rating of AAA, indicating highest degree of safety in timely servicing of financial obligations.