Saturday, 14 December 2013

Tax free bonds : A must for any retirement portfolio

Tax free bonds have been coming out in droves over the last year.  The Indian government empowered multiple companies to issue tax free bonds to help generate working capital.  This has given a unique opportunity for retail investors to lock in an almost risk free guaranteed rate of return for long periods of time.  For early retirement enthusiasts like myself, tax free bonds provide a much needed route to invest a part of the portfolio to generate risk free returns.  There are three big concerns for any early retiree, that he or she has to solve to enable a successful exit from the usual salary based working environment.  Tax free bonds solve two of these concerns in the most efficient manner possible.  This makes tax free bonds a no brainer key component of each and every early retirement portfolio.

Lets take the example of Ramesh Arora, who is in his 50s and lives in Mumbai with his wife and younger son Rahul.  His elder son Raghav is married and lives in Pune.  Rahul is ready to retire now, and expects to spend Rs 20000/- per month on expenses for himself and his wife.  He does not want to burden his elder son for living expenses, while he still needs to take care of his younger son for a few more years before he is up on his own.  Ramesh has 3 big concerns that he must address.  The key is to establish a portfolio that gives him CONSISTENT returns every month, in a GUARANTEED manner, and the returns need to keep up with INFLATION.  While Ramesh was actively working, his monthly salary took care of all 3 aspects.  His salary was CONSISTENT, in the sense that he got his paycheck every month.  His salary was GUARANTEED, in the sense that, as long as he kept going to work, he was sure he would get that salary.  And finally the salary would increase every year keeping up with INFLATION.  Now in retirement, with the monthly salary gone, Ramesh needs to ensure the same 3 aspects are covered by some other means.

Fortunately for Ramesh the Indian government has come out with tax free bonds that simplify his retirement portfolio considerably.  Ramesh's first requirement is that he gets monthly Rs20000/- in his bank account for living expenses in a consistent manner.  This amounts to Rs240000/- (Rs 2.4Lakhs) per year.  Since Ramesh is only in his 50s he is still not considered a senior citizen, and cannot avail of the tax breaks given to citizens over the age of 60-65. If he invests approx Rs 27Lakhs in tax free bonds he will get a yearly return of about 9% tax free on this, which amounts to Rs 2.4Lakhs per annum.  This is a a sure fire way to ensure that his income his consistent per month, and also he does not lose any of it to income taxes.  The second aspect of GUARANTEED returns is also met since all of the tax free bonds are from highly rated companies with the risk of default being almost nil.  The only aspect that is not covered is INFLATION.  At the end of the bond term of 10 or 15 or 20 years, his expenses would have gone up considerably due to inflation, and the fixed returns from the bonds would not suffice to cover his increased expenses.  To take care of inflation, he should have a separate component of his portfolio invested in avenues that provide inflation indexed returns.  This could be real estate rental income, or equity mutual funds etc.  However the key here is that he can rely on the tax free bonds to provide his regular monthly income, and leave the rest of his portfolio to generate higher risk inflation indexed returns that he does not have to depend on a monthly basis.  This is the best way to structure his portfolio, divided into steady income generating portion, and inflation indexed portion.

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