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The volatility in the capital markets has resulted in most investors turning to the relative safety of bank fixed deposits (FDs). However, FD rates currently aren’t very attractive and even with the recent liquidity sucking measures taken by the RBI, banks seem to be in no hurry to raise rates.

Therefore, investors who would prefer to lock-in their money over the next 10 years for an attractive return and better safety than FDs may consider the forthcoming Bhavishya Nirman Bonds (BNBs) issue of the National Bank for Agriculture & Rural Development (Nabard). The issue is slated to hit the market anytime before the end of the current fiscal.

Since the current issue price is not known, we will examine Nabard’s last issue of these bonds (November 2008) to understand the structure and tax benefits of the instrument.

BNBs are essentially 10-year zero coupon bonds. Last time around, the bonds had an issue price of Rs 8,500 and face value of Rs 20,000. The term was 10 years. Both the face value and the term are going to remain constant for this issue too.

What this means is that for an investment of Rs. 8,500, an investor will receive an amount of Rs 20,000 after 10 years. In other words, the face value in this case is the maturity value. The usage of the term ‘face value’ in place of what is normally understood as maturity value is on account of the unique structure of zero coupon bonds.

Zero coupon bonds, also known as deep discount bonds, are bonds that offer no interest ie 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, as mentioned above, the issue price is Rs 8,500 whereas the face value is Rs 20,000.

The discount of Rs. 11,500 is the return for the investor.The 10-year tenure of the bond acts like a lock-in. Therefore, to provide liquidity, the bonds are listed on the BSE. BNBs can be held both in the physical as well as the dematerialised form.

However, note that the bonds held in physical form being negotiable instruments are transferable by endorsement and delivery by the transferor. Hence, for safety considerations, it would be better if the bonds are held in demat form. Further, for selling on the exchange, holding the bonds in demat mode is compulsory.

Tax liability
The difference between the issue price and the maturity value would be taxed as 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 2020 ie, the year of maturity.

Actual numbers may differ depending upon how inflation behaves over the next 10 years. This is because inflation is the major parameter that is taken into account by the government before releasing the cost inflation index for each year.

Rate of return
Basically, Rs 8,500 growing to Rs. 20,000 over a period of 10 years yields a rate of return of 8.93% pa. However, the same is subject to tax as mentioned above.

In other words, the gain of Rs 11,500 would be subjected to a tax of 10% ie Rs. 1,150. The net amount left over with the investor would be Rs 18,850 which works out to a post tax yield of 8.29% pa.

Currently, bank fixed deposits offer an interest of around 7-7.5% pa. To that extent, we expect the issue price of BNBs to be higher to reflect the current yield. However, note that the interest on bank deposits is fully taxable at the slab rates applicable to the investor.

Therefore, investors falling into the tax slabs of 30% would be better off investing in the bonds whereas for other investors, bank deposits could prove to be a comparable alternative.

However, when dealing with interest rates, they say, either predict a date or a rate but never both. In other words, predicting the movement of interest rates, especially over long periods of 10 years is almost impossible.

Based on the current environment, bank FDs would be as good for investors in the lower tax brackets. However, as mentioned earlier, rates on bank FDs will vary with the external environment. On the other hand, BNBs offer investors an opportunity to lock-in at the contracted rate of interest for all of 10 years.

For example, those investors who had invested last time around are still enjoying the 8.29% post-tax yield in spite of the fact that rates of bank deposits have plummeted.

To sum
At the end of the day, the Nabard bonds offer a safe, secure and reasonably attractive avenue for the fixed income investment needs of an investor. In the current volatile financial environment, long-term investors cannot ask for more. Add to it the pedigree of Nabard and it is like icing on the cake.

The writer is director, Wonderland Consultants, a tax and financial planning firm.