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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Risk in tax free infra bonds

Posted by Muthu on December 10, 2013

I’ve got into Twitter again and hope to be regular in tweeting this time. Since I write blogs not more than couple of times a month; Twitter would help me to share thoughts and quotes on a regular basis. Those who are interested can follow us @thewisewealth. 

Generally there is a view that tax free infrastructure bonds are risk free. It does have a risk known as reinvestment risk. 

Let us assume you’ve invested in a bond that offers a tax free return of 8.8% per annum for next 15 years. The idea you’ve is that for the next one and half decades, you would continue to enjoy tax free fixed income. This holds good only if the interest rate remains where they are now. 

We all know that interest rates are cyclical. It keeps going up and down in tandem with inflation levels. Let us assume that the 10 year G-Sec levels falls to 6% in the next 2 years. The company which is paying you 8.8% now would be able to raise money at 6% from the markets. Why pay 2.8% more when cost of capital has become cheap? It may call the bonds back and return the capital to you.

When you try to reinvest the capital again, you would receive only 6%. This 2.8% loss of income is known as reinvestment risk. Also there is no guarantee that there would be tax free option available at the time of reinvestment. Not only the income may fall but it also can become taxable.

To my understanding, other than G-Sec all other kinds of bonds are callable.

If the interest rise in the economy instead of going down, the infra company stands to gain. Let us assume the interest rate goes up to 10%, the company would still continue to pay you only 8.8%. As an investor, you don’t have any option to call back the bond. Of course, you can sell it if you find a buyer in the secondary market. But you’ve sell it at a loss as the interest rates have gone up. Capital erosion, which every bond investor dread, happens in this scenario.

I’m not against tax free infrastructure bonds. It is helpful for people in the higher tax brackets. All I want you to be aware is that the terms and conditions of these bonds cannot be taken for granted.

As we’ve seen above, the issuer enjoys the best of the both world- rising and falling interest rates. As investors, we may get hit ‘unfairly’ on both the scenarios.

Crux: There is no such thing as risk free.

8 Responses to “Risk in tax free infra bonds”

  1. Dheeraj Khetan said

    There is no Put/call option in Tax Free Bonds. So the risk you are talking about is not there.

  2. Muthu said

    Callable is not same as ‘call’ option. Bonds can be called back by the issuer before maturity.

    • Raju said

      There are no mechanism under which these tax free bonds can be called before maturity in normal circumstances (I don’t know about what happens if any of these PSU companies goes bankrupt in the middle and the Govt decides not to support it).

      • Muthu said

        On what basis you say this? Has it been mentioned that the bonds would never be called till the term ends? Please clarify. The issuer has implied power to call bonds when they deem fit.

    • Dheeraj Khetan said

      it is clearly mentioned in prospectus that no put/call till maturity.

  3. Shankarraju said

    Hmm… In both ways investors are impacted. Thanks Muthu for the information. WOndering why such products are allowed by government in first place?

  4. Lakshmipathy G said

    Thanks for the information. This cleared my myth of thinking Tax free bonds are suitable for everyone who wants Risk Safe.

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