REC Invites Bids For Deep Discounted Bonds: What Are These, Should You Invest?

Rural Electrification Corporation Limited (REC) is set to launch a rare and significant zero-coupon bond issuance, inviting bids on September 30, 2024. The bonds will mature on November 3, 2034. These bonds, rated AAA by CRISIL Ratings, will be allotted to successful bidders on October 3, 2024, in institutional market.

What Are Deep Discount Bonds?

A deep discount bond, such as the one REC is issuing, does not pay interest throughout the holding period. Instead, the investor purchases the bond at a significant discount, and the issuer guarantees repayment of a higher amount at maturity. For example, if an investor purchases a bond for Rs 50,000 today, they will receive Rs 1 lakh at maturity, depending on the discount structure.

A comparable product in the market is the Government Securities (G-Sec) STRIPS, which are also zero-coupon bonds. G-Sec STRIPS function similarly to deep discount bonds, where the gains are treated as long-term capital gains, and investors only pay taxes upon maturity. This is beneficial for Ultra-HNIs, as they avoid annual tax liabilities, which typically apply to instruments like Fixed Deposits (FDs) that accrue interest income each year and are taxed annually.

Deep Discount Bonds: Tax Efficiency and Appeal

The Central Board of Direct Taxes (CBDT) has granted REC permission to issue these deep discount bonds with favorable tax treatment. Instead of being taxed as interest income annually, the gains will be taxed as long-term capital gains upon maturity. This structure is particularly attractive to high networth individuals (HNIs) and family offices, as it allows the investor to defer tax payments until the bond matures, providing a tax-efficient investment option. The total permissible raise through this issuance is Rs 2,517.85 crore, with a face value of Rs 5,000 crore.

Example of Tax Benefits

Let’s assume an investor earns 7% interest on a Rs 100 investment. If they are in the highest tax bracket, they would normally pay around Rs 3 in taxes on the Rs 7 interest income each year. However, with REC bonds or G-Sec STRIPS, the tax on this interest income is deferred. The Rs 3 tax that would otherwise be paid each year can be reinvested at the same 7% rate, allowing the investor to earn interest on this deferred tax. Over a 10-year holding period, this results in significantly higher overall returns compared to other interest-bearing instruments, such as FDs, where taxes are deducted annually.

Market Potential and Liquidity

These REC deep discount bonds will be listed on both the BSE and NSE cash segments, allowing retail investors to trade them easily. Moreover, given their liquidity, REC bonds may trade at yields lower than comparable G-Sec STRIPS, yet still offer attractive pre-tax returns of over 9%, assuming they can be purchased at a yield of around 6.5%.

Deep Discount Bonds: Should You Invest?

Due to their tax efficiency and the potential for attractive returns, these deep discount bonds are expected to be in high demand, particularly among super HNIs and family offices. The ability to defer tax payments until maturity, combined with strong credit ratings and liquidity, makes these bonds a compelling investment alternative for those seeking long-term capital growth.

Suresh Darak, founder & director of Bondbazaar, said, “REC’s upcoming deep discount bond issuance is a rare and captivating opportunity for high-net-worth investors seeking tax-efficient and long-term growth. With favourable tax treatment granted by the CBDT, investors can defer tax payments until maturity making these bonds especially attractive compared to traditional interest-bearing instruments.”

Rated AAA by CRISIL and with a maturity of November 2034, these bonds offer strong credit security combined with liquidity. These bonds will be listed on both the BSE and NSE cash segments allowing retail investors to trade them easily, he added.

“Moreover, given their liquidity, REC bonds may trade at yields lower than comparable G-Sec STRIPS yet still offer attractive pre-tax returns of over 9% assuming they can be purchased at a yield of around 6.5%. This will surely help investors focused on capital growth particularly to HNIs and family offices,” Darak said.