The new Government of India (Taxable) Bond, 2013 (also known as the 7.75% RBI Bond) offers you an interest rate of 7.75% for a period of seven years. The interest will be paid half yearly or at maturity, as per your choice.
As the name suggests, the interest on it is taxable. Depending on your tax bracket, this could translate into a return of anywhere from 5.425% (for the 30% bracket) to the full 7.75%, after tax. Also, the principal amount you invest in the bond is also not eligible for any tax deduction. Nonetheless, the interest on offer brings it into competition with several alternative savings instruments. So how does this return compare with the other options on offer?
The most obvious competitors are bank FDs. A 6-year deposit with the State Bank of India (SBI) will get you 6%. However, if you are willing to be a bit more adventurous and try private banks, a deposit with RBL Bank will get you 7.8% whilst one with ICICI Bank will get you 7.25%. Interest on bank fixed deposits is also taxable. However, there is the 5-year tax saving fixed deposit whose principal is eligible for a tax deduction under Section 80C. Interest earned on this FD is taxable.
The big advantage FDs enjoy is their relative liquidity – you can prematurely break an FD by paying a penalty of about of 1%. You can also borrow against them. On the other hand, you cannot transfer or trade the 7.75% Bonds and you cannot offer them as collateral for loans.
The 7.75% bond will beat most small savings schemes in terms of interest rate. We give you the interest rates on these here. One big exception is those targeted specifically at senior citizens such as the Senior Citizens Savings Scheme (SCSS) and the PMVVY (Pradhan Mantri Vaya Vandana Yojana). The former offers a rate of 8.5% and the latter offers 8%. However, you have to be 60 or above to be eligible for these.
Many of these schemes also carry tax benefits. Investments in NSCs are tax deductible under section 80C and so is the interest on them. SCSS deposits are also eligible for tax deductions under Section 80C. As mentioned above, the 7.75% bonds carry no tax benefits.
Finally, in terms of liquidity, small savings are also highly illiquid and have no great advantage over the 7.75% Bonds here.
In the mutual fund universe, the closest competitors of the 7.75% Bonds are debt mutual funds. Funds which invest wholly or even partly in stocks stand in a different category altogether and we will not consider them here. This is because stocks or equity carry a lot more risk than bonds or debt.
The 5-year returns on debt funds go from 7.4% for liquid funds to 9.2% for credit opportunities funds. The 10-year returns go from 7.5% for short term gilt funds to 8.36% for short-term debt funds. However, even these funds have fluctuating returns and have no guarantees. On the other hand, the interest on the 7.75% bonds is guaranteed.
In terms of tax, mutual funds win handsomely. Debt mutual funds held for more than three years are taxed at 20% with indexation. In case of shorter periods, returns are taxed as per your slab. The method of tax calculation involved (called first-in-first-out) considers each withdrawal to be part capital and part interest, results in a lower tax burden for many taxpayers.
If you look at liquidity, mutual funds are highly liquid and you can redeem your money at any point in time for most types of funds. You may, however, be subject to a charge called exit load if your period of holding is too short. For most debt funds, this charge is only imposed up to the first three years of holding.
If you are absolutely risk-averse and willing to lock away your money for seven years, the 7.75% Taxable Bonds may well be just what the doctor ordered. However, India’s inflation remains an ever-present danger. Currently hovering close to 4.9%, it has historically been much higher ranging from 8-12% from 2012 to 2014. If you are in the 30% tax bracket, your effective post-tax return stands at a measly 0.6% (5.4%-4.9%) at present and is liable to dip further if inflation rises. This may well spoil an already dull party.