I was reading an article a few days back which had the headline “Why one should book profit in existing tax-free bonds and invest in new issues” and a couple of financial experts shared their views that investors should book profits in the existing tax-free bonds and invest the sale proceeds in the new issues like the currently running REC tax-free bonds.
Sanjay Shah raised a similar query here yesterday. This is what he had to say:
Hi Manshu / Shiv,
I had been allotted 1,000 bonds of REC in it’s March 2012 issue. Period is 15 years carrying an interest of 8.12% (HNI category). It’s currently listing at a premium of 9%. Given that I am in the 20% tax bracket and that the sale of the REC bonds will mean profits earned will be added to my income, plus 0.5% brokerage charge, do you recommend I sell those and re-invest in this issue? (and thus replace myself in the Retail category).
Additionally, I had been allotted 336 bonds of PFC in it’s February 2012 issue. Period is 10 years carrying an interest of 8.2% (HNI category). It’s currently listing at a premium of 6%. Given that I am in the 20% tax bracket and that the sale of the PFC bonds will mean profits earned will be added to my income, plus 0.5% brokerage charge, do you recommend I sell those and re-invest in this issue? (and thus replace myself in the Retail category, plus net a 15 year bond instead of a 10 year bond).
I had invested in the earlier bonds with a view of keeping them till end of tenure and the same holds true this time as well. However, I don’t have enough funds to remain invested in all three issues and hence need to decide if I should shift which series I am invested in.
Thanks in advance.
Here is what Manshu had to say in response:
Manshu December 3, 2012 at 7:11 am
Based on your situation I don’t see any value in selling and shifting to a lower interest bearing bond. If anything, the decline in interest rates will mean that the premium on your existing bonds go up even more.
Here is what I had to say in response:
Shiv Kukreja December 3, 2012 at 4:45 pm
Hi Sanjay… If I were at your place, with funds limited for two investments only, I would have kept my investments in the old tax free bonds only. This is because of two reasons – first, if you sell your old bonds in the markets now, you’ll have to pay STCG tax on the capital gains made till date as per your income tax slab. Second, the market value for these new bonds would be as per the yield to maturity (YTM) for the new buyer and not as per 7.88% or 7.72%.
But, if you can manage to hold your old bonds for 2-4 months more till your investments complete one year and you also manage to buy and hold the new bonds till their maturity, then probably it makes sense to try replacing yourself in the Retail category. This would result in a YTM of 7.88% or 7.72% for you. Am I clear to you or was it too complicated?
Taking from there, I have a view that if you are in 30% or 20% tax bracket, it is not a great idea to invest in this year’s tax-free bonds with the proceeds from the sale of last year’s tax-free bonds. Firstly, you will have to pay short-term capital gain (STCG) tax as per your income tax slab. So, your returns would effectively get reduced by the STCG tax you pay and also by the brokerage you pay when you sell your existing bonds.
Secondly, as all new issues will carry the “Step Down” feature and the buyers of these bonds in the secondary markets will not get the additional coupon rate of 0.50% per annum, these new tax-free bonds will always trade at a market price factoring into the reduced coupon rate.
Also, as Manshu pointed out, the decline in interest rates will mean that the premium on your existing bonds go up even more. This is because the existing REC tax-free bonds are already trading at a higher yield to maturity (YTM) of 7.49% as compared to the original coupon rate of 7.38%. So, if the yields of both these bonds are equal, then either the old tax-free bonds will appreciate in value or the new tax-free bonds will fall in value.
In what situation or when should you book profits in the old tax-free bonds?
1. If an investor wants to book profits, he/she should do that either after completion of 1 year from the date of allotment or after the next ex-interest date. Investors in the 30% or 20% tax bracket can save their tax outgo by selling these bonds after a year and pay only 10% flat long-term capital gain (LTCG) tax on these listed bonds. Moreover, the market price of these bonds fall two days before the ex-interest date. So, one can sell these bonds after this date to minimise their tax outgo.
2. If you are 100% certain that you will hold these bonds for more than 7-10 years, then also you might think of selling the existing bonds. But, there would not be extraordinary gains out of it.
Many of the brokers might encourage you to sell your existing investments in tax-free bonds to invest in the new tax-free bonds. I would say you should do your homework first and your objectives must be clear before you follow your broker.