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Inflation-proof bonds now at a bank near you

The Inflation Indexed National Savings Securities-Cumulative is now available for subscription. Return on such bonds are better than FDs, but watch out for the downsides before you opt for one.
By Vivina Vishwanathan | Hindustan Times
UPDATED ON DEC 28, 2013 01:44 AM IST

The Inflation Indexed National Savings Securities-Cumulative (IINSS-C) is now available for subscription. The issue will remain open till December 31. These securities are an attempt to introduce instruments that will protect savings against inflation. Here is a quick take on how this bond looks.

What it offers

This bond is like any other government security bond. The only difference is in the way interest is calculated. The Reserve Bank of India stated in a notification, “Interest rate on these securities would be linked to final combined CPI (Consumer Price Index).

Interest rate would comprise two parts — fixed rate (1.5% per annum) and inflation rate based on CPI and the same will be compounded in the principal on half-yearly basis and paid at the time of maturity. The final combined CPI will be used with a lag of three months, i.e., final combined CPI for September 2013 will be used as reference CPI for all days of December 2013.”

For example, if inflation rate during a six-month period is 5%, then the interest rate for those six months would be 5.75% (i.e. fixed rate of 0.75% for the half-year period and inflation rate of 5%). Interest rate will be accrued and compounded in the principal on half-yearly basis and paid along with principal at the time of redemption.

You can invest a minimum of Rs 5,000 and a maximum amount of `5 lakh in a financial year. You can also invest on behalf of a minor. The tenure of the bond is 10 years. Though, premature redemption is allowed, it comes with penalty — you have to pay half of the last payable coupon as penalty.

For example, if last payable coupon is Rs 1,000, then Rs 500 would be charged as penalty. However, there is a mandatory lock-in period. For senior citizens above 65 years, premature redemption is allowed after one year. For others, it is allowed after three years.

Tax treatment

The RBI press release explains that tax treatment on interest and principal repayment would be according to the extant taxation provision. The notification says that interest on the bonds will be taxable under the Income-Tax Act, 1961 as applicable according to the relevant tax status of the bond holder.

This means it would be subject to the income tax slab rate applicable to the investor and hence no tax incentive for interest earned which makes the nominal return less attractive. For example, if the coupon rate for these bonds is 11.5% in a given year, then the post-tax return for that year for someone in the highest tax bracket will be 7.95%.

That essentially results in a post-tax negative real return for people in the 30% tax bracket.

When you are opting for this product, besides the interest rate look at the post-tax return. “The interest on these bonds as taxable on the applicable slab rate,” said Gautam Nayak, chartered accountant, Contractor, Nayak and Kishnadwala.

“Hence, though the pre-tax return will be higher than inflation at the current rate, the post-tax return in most cases will be lower than inflation. For instance, for individuals in the highest tax bracket, the returns will be low. If the tax structure was on capital gains with indexation benefit, the post-tax returns would have beeen much higher.”

There are other tax related issues as well. “When we look at the tax treatment there are better products in the market such as the tax-free bonds especially if you are in the highest tax bracket,” said Anil Rego, CEO, Right Horizons, an investment advisory firm.

If you follow the accrual method, this essentially means that though you will not receive the interest in your hand, but while calculating tax liability you will have to add the interest amount to your income every year.

Our take

Considering that the tax department takes a part of the benefit, the real return from these bonds looks unattractive. Besides this, it is a 10-year bond and comes with a lock-in period too, and the penalty is also high.

Moreover, for retail investors and senior citizens who pay less tax, though this return may seem attractive, there is no provision for regular interest payout.

If you are in the highest tax bracket, tax-free bonds at present could turn out to be a better option. Individuals who will benefit from these bonds are retail investors who fall in the lowest tax bracket of 10%. But for the fixed deposit investor, these bonds are the next best thing to sliced bread.

A pre-tax 8% or 9% compared with a current 11.5% return is obviously superior. Long-term fixed deposit investors should go all out for this bond. Others should explore a mix of tax-free bonds and equity funds for their long-term investment needs.

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