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These offer investors an opportunity to lock-in at the contracted rate of interest for all of 10 years

The volatility in the capital markets has resulted in most investors turning to the relative safety of bank fixed deposits (FDs). However, FD rates, to begin with aren't very attractive and after the tax incidence, what is left doesn't even cover inflation. However, very soon, at least those who do not mind locking in their funds over the next 10 years for an attractive return and better safety than FDs may just get such an option.

In a notification issued in April, the central board of direct taxes has allowed the Rural Electrification Corp to issue zero coupon bonds. The issue is slated to hit the market this fiscal. As per the terms of the notification and some basic calculations, the bonds will have an issue price of Rs 11,055 and a face value of Rs 30,000. The term is 10 years. What this means is that for an investment of Rs 11,055, an investor will receive Rs 30,000 after 10 years. This yields 10.5% pa!! While this point is elaborated further a little later, first let's understand the nature of this instrument.

In the case of zero coupon bonds, the face value is the maturity value. Also known as deep discount bonds, these bonds offer no interest per se i.e., the coupon is actually zero. However, these are issued at a discount to the face value and the difference between the issue price and the face value is essentially the return that the investor gets. In this case, the discount of Rs 18,945 per bond (Rs 30,000 - Rs 11,055) is the return for the investor. The 10-year tenure of the bond acts like a lock-in. Therefore, to provide liquidity, in such cases, the bonds are listed on the stock exchange. It is not known whether these particular bonds will be listed or not (the details aren't out yet), but note that similar bonds from Nabard issued earlier are listed on the BSE.

Tax liability

The difference between the issue price and the maturity value would be taxed as long-term capital gains. The investor has the option of paying capital gains tax @10% on the difference between the maturity value and the issue price or @20% on the difference between the maturity value and the indexed issue price. There is no TDS. Our calculations indicate that an investor would be marginally better off opting for the 10% rate. However, this is based on a forecast of what the cost inflation index could be in 2021, which would be the year of maturity. Actual numbers may differ depending upon how inflation behaves over the next 10 years.

Rate of return : Basically, Rs 11,055 growing to Rs 30,000 over a period of 10 years yields a rate of return of 10.5% pa. However, the same is subject to tax as mentioned above. In other words, the gain of Rs 18,945 would be subjected to a tax of 10% i.e. Rs 1,895. The net amount left over with the investor would be Rs 28,105 which works out to a post tax yield of 9.78% pa. Currently bank fixed deposits offer an interest of around 7%-7.5% pa, pre-tax! That being said, however, predicting the movement of interest rates, especially over long periods of 10 years is almost an impossibility. Depending upon the future financial environment and the behaviour of inflation, bank FD rates would vary. On the other hand, these bonds offer investors an opportunity to lock-in at the contracted rate of interest for all of 10 years.

To sum

The new direct tax code which is slated to become effective from April 1, 2011, will treat long-term gains, computed necessarily after indexation, as normal income of the taxpayer and tax it at the slab rate applicable. In that case, the entire equation changes but a rough back-of-the-envelope calculation reveals that the REC bonds would be extremely attractive to one and all, non-taxpayers as well as taxpayers, irrespective of their tax bracket.

Source: http://digital.dnaindia.com/