Most post-budget discussions on your investments are about the impact on the equity market, and the broad trends in the bond market. That apart, as a corollary of the budget, certain bonds have become more attractive for you than earlier. Let’s have a look.
The tax rates on individuals remain broadly the same as earlier, but there is a higher surcharge on people in a certain income bracket, popularly referred to as the “super-rich” tax. As a result of the higher tax, the net return on investments taxable at your slab rate is that much lower now. However, unwittingly, this will positively impact returns on a particular category of bonds, which is tax-free PSU bonds. Two things have happened in the budget: it was expected that prior to the budget, fresh issuances would be announced. If that had happened, it would have meant higher supply of bonds in this category and, thus, yields on existing bonds would have moved up and prices would have come down. However, there is no further issue of tax-free bonds. Moreover, there has been a rally in bonds recently, and yields have come down.
The way to look at the effective yield or return on a tax-free bond is the tax-free equivalent. So if you invested in another regular PSU bond, the yield you would have required to get a matching return, as you have to pay tax at your slab rate on coupons (i.e. interest) received on a regular bond. The method to calculate this, as a ballpark, is to divide the yield (or annualized return) you are getting on the tax-free PSU bond with 1 minus your tax rate. If your tax rate has moved up due to higher surcharge, the pre-tax equivalent return has become more attractive. For illustration purposes, let us say, you are getting a yield of 5.9% on a tax-free bond. If you are in an income bracket of ₹10 lakh to ₹50 lakh per year, your tax rate is 31.2%. The grossed-up equivalent for a tax-free PSU bond at a yield of 5.9% is 5.9% divided by 1 minus 31.2% i.e. 8.6%. This means you need to get a yield of 8.6% on a regular coupon paying AAA-rated bond to match 5.9% of the tax-free bond, which is not available today, after the rally.
If you are in an income bracket of ₹50 lakh to ₹1 crore per year, at the tax rate of 34.32% (including surcharge and cess), the grossed-up yield is 9%. At the highest bracket of more than ₹5 crore, at 42.74% (including surcharge and cess), the grossed-up yield is 10.3%. Yes, you read it right, 10.3% in today’s scenario when the overnight repo rate from the Reserve Bank of India (RBI) is 5.75% and there are strong expectations of further rate cuts. Net-net, the higher surcharge in the budget has made the value of tax-free coupons (or interest payments) more attractive.
Another instrument on which the effect will be similar is preference shares. Though these are technically shares, by virtue of a defined maturity date and defined dividend (similar to coupon) and a credit rating of the instrument, it can be talked about in the same breath as bonds. Being shares, dividends are tax-free in the hands of investors. There is a rule that for an individual, if the dividend from equity and preference shares is more than ₹10 lakh in a year, there is a tax of 10% (plus surcharge and cess as applicable). Even then, it is lower than your slab rate (30% plus surcharge and cess) applicable on bond coupons. Let’s do a similar back-of-the-envelope calculation for the tax-free equivalent or grossed-up yield. Assuming a yield of 7.7% from a preference share, at a tax rate of 31.2% (assuming your dividend from shares is less than₹10 lakh per year), the effective yield is more than 11%. If you are in an income bracket of ₹50 lakh to ₹1 crore per year, at a tax rate of 34.32% (including surcharge and cess), the grossed-up yield is 11.7%. At the highest tax bracket of 42.7%, the effective yield is, hold your breath, 13.45%. A return of more than 13% from a good quality issuer was last heard of decades ago, when inflation and interest rates were much on the higher side.
In short, tax-free receipts in your hands effectively push up your return. Portfolio allocation towards debt happens mostly through mutual funds, driven by the advantages on offer. That apart, you may reap the benefits discussed above, by allocating a part of your portfolio, earmarked for debt, to tax-free PSU bonds. Preference shares are in short supply, so talk to your financial adviser regarding its availability.