Today is the last day for subscription for the REC's (Rural Electrification Corporation) tax free bonds - which many analysts have recommended as a good investment option. I disagree to the basis of the recommendation which seems to be just the tax angle. Only naïve fixed income investors use Fixed Deposit as investments and hence the rest of the post assumes this extent of sophistication.
Most analysts who recommend the tax-free REC bond issue convert the coupon of the bond to a pre-tax yield adjusting for the tax bracket (taking the highest tax bracket of 30%) making the 7.88% p.a. yield to 11.26% (=7.88%/(1-0.30)) and claim it is higher than the pre-tax yield of most other fixed income instruments. The tax adjustment rate used in the calculation above should be the tax rate that makes the "Tax-free" bond yield comparable to "Normal" bonds in the market and not simply the tax slab of the individual/company. Fixed income instruments are taxed at 10% without indexation or 20% with indexation - which makes the recommendation of the analysts totally flawed.
If the long term taxation rules of Fixed income instruments are to be observed (Link) they are either 20% with indexation or 10% without indexation. This practically puts a cap on the potential upward revision of the pre-tax yield of the "tax-free" bond to 1/(1-0.10) and not 1/(1-0.30) - using this base case the pre-tax yield of the REC bond for 15 year turns out to be 8.76% (=7.88%/(1-0.10)). This is not screamingly higher than the other available instruments available in the market. Just to give a sense, SBI Dynamic Bond Fund (Link) has an average YTM of 8.60% and average maturity of 11 years; no comments on the liquidity angle where the mutual fund route is definitely more liquid. There are other bond funds with longer duration and equivalent credit quality.
If the indexation angle is taken into consideration, (data here), the indexation benefit for the last 1, 5, 10 and 15 years are 8.5%, 10.92%, 9.06% and 10.49% per annum respectively. This practically means the interest income from fixed income instruments after adjusting for the indexation benefit, there is hardly any income and hence hardly any tax payable. There could be instances of tax credits in some of the years. It is to be noted even in the Direct Tax Code, the indexation benefits are likely to remain intact. Hence after the indexation angle, I do not see any advantage of subscribing to the REC bond vis-a-vis the fixed income instruments available through the Mutual fund route.
The main risk to my recommendation is that the fund manager drastically changes the duration/credit profile. Having said that, the bond funds have the diversification benefit.
Bottomline: REC Tax-free bond is inferior to other available fixed income investment routes with respect to the net tax free yield at the hands of the investor.
Update: Market seems to echo a similar sentiment as mine with respect to these Tax Free Bonds (TFBs). Here is a Business Standard report of why TFBs have been disappointing this year.