As I write this, one tax free bond issue has just closed — oversubscribed 10 times — and another one is scheduled to open in a week. As you read this, others may have opened (and closed) or been announced. The government has plans (and authority from Parliament) to raise an enormous amount of funds via this route so a fair amount of activity is expected.

In our practice we normally do not advise our younger investors to opt for this investment avenue. The reason is simple: the interest on these bonds is not reinvested automatically (and thus compounded). Instead it is paid out annually to the investor and unless the investor has the forethought and discipline to reinvest it on her own, she will re-visit this investment 10 or 15 or 20 years later and discover that it has not appreciated and its real value has in all probability declined, which will not be a happy discovery.

However, the very defect that makes this inadvisable for younger investors makes it perfect for older ones who are looking to their portfolio to provide them some income and who are less concerned about portfolio appreciation than they are about portfolio preservation.

Should you invest in Tax Free Bonds (TFBs)? If you’re an older investor, most definitely. They are safe: they are issued only by government-owned entities and therefore have the sovereign guarantee of the government behind them. This makes them probably the safest form of investment available today. The interest paid out annually is completely tax free and doesn’t even have to be included in your annual income when filing your return. The interest payouts have historically been very prompt and are credited directly to your bank account, so logistically too it is a simpler process than receiving a cheque and having to traipse to the bank to deposit it. If you’re a younger investor, not so much. Far better to invest in equity and let your portfolio appreciate over time. Too few of us have the discipline to not splurge when those interest payouts drop into our bank account.

What kind of return can you expect from TFBs? Over the last few months interest rates have been gradually coming down and this is reflected in the interest rate offered on these TFBs. In the last round (pre-2015) the interest offered was around 8+% per annum. This time it’s closer to 7.30% (at the lowest slab). The interest rate rises if you opt for longer tenures of the TFBs and if you invest up to Rs.10 lakhs. However, even at 7.60% (which was the Power Finance Corporation TFB interest for a 20-year bond paid to an investor who invests up to Rs.10 lakhs), this is the equivalent of earning 10.86% taxable interest (if you’re in the 30% tax slab), which is a great rate of return for a completely risk-free guaranteed investment.

What period should you invest for? This is an interesting philosophical question, actually. The TFBs are typically offered for 10, 15 and 20 year tenures. We’ve noticed a lot of older investors opting for a shorter tenure (which, by the way, pays the lowest interest). Their logic is “we’re not sure we’re going to be around for 20 years, so why bother with a 20 year bond?” The underlying unspoken rationale seems to be that they think they can take the money with them into the hereafter. All scientific, religious and economic theory points to the contrary — you can’t take it with you when you go. There is no economic and legal logic to NOT opting for the longest tenure available. The longest tenure offers the highest return. In case you ever need to sell the TFBs in the open market (which you can do), the longest tenure ones will provide the highest resale value (particularly if we’re in a declining interest rate scenario). You can bequeath them so that if you don’t outlive the TFBs, your heirs will thank you for inheriting a safe investment that provides a tax free return.

Should you divest from other investments to invest in TFBs? This is a trickier question and depends very much upon how old you currently are, how your portfolio is structured and how large it is. An investor who is now 88 provided us with a possible rationale for this course: she has a large holding of shares in a blue chip company. She compared the dividend that she usually receives on this holding with the tax free interest she would receive if that money were in TFBs. The TFBs provided a higher return. Because she is 88 (and has no children), she isn’t as interested in portfolio appreciation as a 60-year old might be. So, for her it made sense to sell a portion of her equity and invest it in TFBs to ensure a higher, safer return. Your mileage may vary.

Paperwork? Inevitably, yes. Although some TFBs are offered in physical form (that is, you get a bond certificate to keep safely under lock and key), the best way to invest is via a demat account. This also enables you to easily sell the TFBs should you ever need to. If you don’t have a demat account, do yourself and your heirs a favour and get one. Most banks can help you open one.

Are there downsides to TFBs? Some, but not that significant. One, is that you should invest via a demat account, so you need to have one — we’ve found that some older investors don’t. Two, the interest is paid out annually in one shot which probably will not coincide with your spending needs, so that might require a bit of cash flow management — nothing that can’t be handled with a little planning, however.

Conclusion: Invest in Tax Free Bonds for the longest tenure available.