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THE proposal to issue 7 per cent tax-free bonds to investors in the monthly income plans of the UTI that will mature over the next few years may not find favour with investors. That is so because there are better options in the market. The probability of the success rate may have increased substantially if the bond offered 8 per cent.

This is because of the availability of the 8 per cent Government of India Relief Bonds. Investors can invest in this option up to Rs 2 lakh per annum. So, only an investor with a surplus of more than Rs 2 lakh will be interested in converting his holdings in the MIPs to 7 per cent tax-free bonds. Otherwise, it will make sense to receive cash and re-invest the proceeds in 8 per cent tax-free bonds.

It is highly likely that a significant proportion of the investors in MIPs will not have a surplus of more than Rs 2 lakhs. Even if investors have more than Rs 2 lakhs surplus it is difficult to see them opting for the 7 per cent bonds. The standard practice in India is to divide the surplus by the number of family members and then invest in the 8 per cent tax-free bonds.

Another issue is the effect of taxation. Given the prevailing tax laws and the interest rate, only a retired investor with a corpus of more than Rs 5,00,000 will be faced with incidence of taxation. For retired investors to fall in the 20-30 per cent tax bracket, their corpus will need to be somewhere in the region of between Rs 10-15 lakh.

It is possible that retired investors (who are major investors in MIPs) have a corpus that is much less than this. If that were the case a 7 per cent tax-free bond will be unattractive even if they invested up to Rs 2 lakh in RBI tax-free bonds. They are likely to prefer other small-savings schemes, which will offer better after-tax returns.

The 7 per cent bonds will be attractive only if an investor falls in the 30 per cent tax bracket and has in addition already invested Rs 2 lakh in the 8 per cent Government of India relief bonds. Chances are such investors will form a pretty low proportion of investors in MIPs. Things can change if the issue of 8 per cent bonds are withdrawn next year. Till such time investors may not accept the 7 per cent bonds.

Suresh Krishnamurthy

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