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Money Sep 6, 2012

NHAI tax-free: Here’s a bond that will give you 40-50% return!

By R Jagannathan

The State Bank of India's decision to cut fixed deposit (FDs) rates is going to nick you where it hurts most: your wallet.

If you are a saver, this calls for a quick rethink on where you should put your money in order to improve effective post-tax yields.

Remember, the bank's cut isn't the only thing you need to keep in mind. The unkindest cut is the one the taxman will seek, assuming you are in the top tax bracket where you pay 30 percent tax on your FD earnings.

SBI has cut rates on FDs under one year to 6.5 percent; for tenures beyond that the rate is 8.5 percent.

The first point to make is that since other banks are still offering rates in the range of 8.75 percent to 9.25 percent (Punjab National, ICICI Bank and HDFC Bank), its better to move your FDs there before that window closes.

However, even if these windows close, there is a much better alternative for people in the higher brackets, especially those in the top bracket of 30 percent: the near-sovereign- rated AAA tax-free bonds.

And what's more, these bonds can be bought from the stock market in any kind of quantities you may like.

On a Rs 1,000, 10-year bond, you will get Rs 82 in one month from NHAI. Reuters

Consider the National Highways Authority's of India's (NHAI's) two bonds - the 8.2 percent 10-year bond (face value Rs 1,000) and the 8.3 percent 15-year bond.

Around mid-morning on Thursday, 6 September, these bonds were quoting on the National Stock Exchange at Rs 1,093.74 and Rs 1,100.95 - that is at a premium to the face value.

The effective one-year interest rate is thus 7.49 percent for the 10-year bond and 7.53 percent for the 15-year one.

But factor in a tax rate of 30.9 percent (including cess) and the pre-tax yields go up to 10.83 percent and 10.89 percent. That's more than two percent more than the top SBI rate of 8.5 percent and even higher than the highest FD rates now offered by any bank.

Similar tax-free bonds are on offer from the Rural Electrification Corporation, Hudco, Power Finance Corporation, Indian Railways Finance Corporation and some other quasi-state entities (the rates, though vary, so check before you buy). All of them are quoted on either the NSE or the BSE.

The bottomline is this: if we assume that these companies cannot default (they are all owned by the government), they offer better returns than FDs and even beat the current rate of inflation (just under 10 percent for the Consumer Price Index).

Not only that, many of these bonds are up for yearly interest payments shortly - the NHAI bond is due for payment on 1 October, for example - and hence the approximately 7.5 percent yield for a one-month wait is really like getting 90 percent interest annualised.

But that wouldn't be right. Unless you plan to hold on to the bonds (which you should in the current falling interest rate regime), you would have to minus the likely fall in prices after the interest payment date from your interest.

On a Rs 1,000, 10-year bond, you will get Rs 82 in one month from NHAI. Assuming your bond price falls from Rs 1,093 today to Rs 1,043 after 1 October, your effective earnings are Rs 32 for one month [Rs 1,043 (buy price) - Rs 1,093 (sell price) + Rs 82 (interest)].

Rs 32 for a month is Rs 384 annualised. That's more than 35 percent annualised return on today's purchase price of Rs 1,093. Adjusted for your tax bracket of 30.9 percent , it means a pre-tax return of over 50 percent.

How's that for a quick buck even in bonds?

POSTSCRIPT: As one comment writer points out, the NHAI bonds will pay interest for only eight months this year. This means the effectively annualised return would be in the range of 35-36 percent. But as against that, one can carry forward the loss on selling the bond on 2 October. Which against improves the return. Hence though I have not changed the copy to reflect this, I wouldn't be surprised with a notional yield of 40-45 percent in the end.

by R Jagannathan

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