TAX-FREE BONDS- Best Bonds to Invest
A bond is an instrument used issued by a corporate or a Government institute to raise money. Bonds usually offer a fixed rate of interest. However, they may be linked to certain variables such as inflation or a central bank rate.
What are Tax-Free Bonds?
Tax-free bonds are bonds issued by the government to raise money for the developmental purposes of the economy. They have been very popular among investors. The primary reason for this, as the name suggests, is that they are “Tax-free”. The interest earned on these bonds is exempted from tax as per section 10 of Income Tax Act,1961.
These are bonds issued by the government through its public enterprises such as the National Highways Authority of India (NHAI), Housing & Urban Development Corporation Limited (HUDCO), Indian Railway Finance Corporation Limited (IRFC), India Infrastructure Finance Company Limited (IIFCL), National Bank for Agriculture and Rural Development (NABARD), etc. Depending on the government company issuing the finances, the raised money is used for various housing and infrastructure projects.
Read Also: Tax Saving Options Under Section 80C
Features of Tax-Free Bonds
Below we have mentioned some important characteristics of Tax-free bonds which will help you understand more about them.
This bonds are one of the safest investment options available in the market to investors because of their backing by the government. Most of these bonds are rated as ‘AAA’ because of the guarantee from the government. So, there are very low or negligible risks associated with the non-payment or default by these bonds.
- INVESTMENT LIMITS
There is no upper limit on the investments in these bonds.
These bonds offer a slightly higher interest rate to retail investors, i.e individual and Hindu undivided family (HUFs). However, the limit to achieve this higher interest rate is a maximum investment of Rs. 10 Lakhs.
In case an investor makes an investment of above Rs. 10 Lakhs, he is considered a high net-worth individual and does not get the higher interest rate applicable for retail investors.
Tax-free bonds offer coupon rates of 7-9% depending upon different issuers and tenures, these are the annual interest payments that are made to investors. The rate of return offered to retail investors (investments under Rs. 10 lakhs) is generally slightly higher.
The interest is generally paid on an annual basis. There is an option of opting for half-yearly payment. However, this option comes with a hit of approximately 0.15% in the interest rate. Investors also have the option to opt for cumulative payments. In this case the interest is added to the principal amount, and the complete amount is paid out at the time of maturity.
However, if we talk about returns on bonds, then the Yield-to-Maturity or YTM of these bonds is the true indicator. Given the higher coupon rates, the YTM also turns out to be slightly higher for retail investors.
The YTM on these tax-free bonds works out to be higher than the after-tax return of other fixed-income instruments (depending upon the purchase price of bonds i.e at discount or premium)
Tax-free bonds are normally listed on exchanges such as the NSE, and an investor can buy or sell these bonds from the exchange. However, as most investors purchase these bonds for long term investments, trading can generally be fairly illiquid on the exchanges. Even though you may find an exit, volumes and prices can be a problem.
The most important feature of these bonds is the fact that the interest earned from these bonds is tax-free. For taxation purposes it does not matter if the interest payments are annual, half-yearly or cumulative. Under section 10 of the Income Tax Interest payments on Tax-Free bonds are exempted from tax and the investors are not required to pay any tax on this income.
However, any capital gains from selling the bonds within one year from purchase of the bond is taxable at the investor’s applicable slab rate. In the case the tax-free bonds are sold after one year, any capital gains arising will be taxed at 10% LTCG without indexation or at the rate of 20% with indexation benefit.
Tax-free bonds have been issued with long maturity tenures. The general maturities are 10,15 and 20 years. These bonds have a lock-in and investors cannot withdraw them before the expiry.
Benefits of Tax-Free Bonds
- As mentioned earlier, one of the top benefits of investing in Tax-Free bonds is the nature of tax treatment on the interest earned from these bonds. The interest earned on these bonds is completely tax-free under section 10 (15) (iv) (h) of the Income Tax Act, 1961.
- These bonds also provide post-tax returns greater than Bank FDs and several other risk free or low risk bonds. this bonds issued by the government-backed entities have annual coupon rates ranging between 7-9%. At current prices, these bonds have Yield to Maturity (YTM) of around 5-6%. If one is to adjust this for tax (assuming a 30% tax bracket), the pre-tax bond yields compute to approximately 7.2% to 8.5%. This is greater than the interest from other fixed income instruments such as Bank FDs and other bonds after taxation. Bank FDs are currently offering between 5.5% and 7% on a pre-tax basis.
The yield to maturity (YTM) is the rate of return for a bond assuming that the investor holds the asset until its maturity date.
- Tax-free bonds are suitable for investors in higher tax brackets as they can earn more from these bonds as opposed to after paying 30% tax on FDs and getting a lower post-tax return.
For example- A 15-year bond issued by the National Highways Authority of India in 2015 with a par value of 1000 and a coupon rate of 8.30% is trading on NSE at the price of ₹1224. The YTM of the bond comes out to be 5.25% and assuming a 30% tax bracket, this is as good as a Fixed Deposit fetching 7.5% rate.
- It could be a very good option for investors looking for a regular interest income. For investors such as retired individuals, the interest from these bonds can be very helpful in the absence of an active source of income.
- Tax-Free bonds are issued for maturities of 10, 15 or 20 years. This is beneficial for investors who are worried about interest rates falling in the future, as the coupon payments get locked-in for a long period, i.e. the tenure of the bond itself.
Disadvantages of Tax-Free Bonds
Tax-Free bonds may have several advantages, however, they also come with their share of minuses as well.
- The long tenure in these bonds along with the illiquidity implies that the investor must hold onto them for a long time. One must make sure all their short- and medium-term goals have been well planned for and they would not be in urgent need for these funds.
- Even though the bonds are listed on the stock exchanges for trading, they are not very actively traded. Due to the illiquidity, the transaction costs, i.e. the spread can be high. This is an added cost.
- In case of a rising interest rate and inflation scenario, the interest from these bonds may not be able to cater to the rising expenses. The real interest rate from these bonds may be negligible and maybe even negative. Given the long-term nature of these bonds, there are bound to be instances of high inflation.
How can you invest in Tax-Free bonds?
One can invest in Tax-free bonds in either of the 2 available forms, i.e. physical or through a de-mat account during the period when the issue is open.
After the issue is closed, Investment in Tax-free bonds is like investing in stocks as one must open a de-mat account providing necessary verification documents. The dematerialized forms can then be traded at the market prices. These bonds can be traded through various exchanges such as the National Stock Exchange or the Bombay Stock Exchange. Or they could also be traded over the counter.
Tax-free bonds are one of the best options for investments in fixed income securities due to its features like fixed income annually, tax exemption and better returns than other instruments. These bonds provide high returns for low risks along with the safety of capital.
Q1. What are Tax-Free Bonds?
Ans. Tax-free bonds are the bonds issued by the government-backed public enterprises for the purpose of raising money to implement developmental activities. These bonds are exempted from paying tax on annual interest payments as per section 10 of Income Tax Act,1961.
Q2. Who provides Tax-free Bonds?
Ans. Government-backed public sector companies have issued tax-free bonds. These include issuances by companies like Indian Railway Finance Corporation Limited (IRFC) National Highways Authority of India (NHAI), Housing & Urban Development Corporation Limited (HUDCO), Power Finance Corporation Limited (PFC), National Highways Authority of India (NHAI), India Infrastructure Finance Company Limited (IIFCL), REC Limited, NABARD, and NTPC Limited.
Q3. Why invest in Tax-free Bonds?
Ans. Safety of capital, along with steady annual interest income better than other Fixed income instruments are some of the reasons to invest in Tax-free bonds.
Q4. Tax-free Bonds are suitable for which type of investors?
Ans. Tax-free bonds are well suitable for investors in higher tax brackets with a low-risk appetite as these bonds generally provide higher YTMs than the after-tax returns in other instruments.
Q5. How are Tax-Free Bonds different from Tax-Saving Bonds?
Ans. Annual interest earned on Tax-free bonds is tax-free. They do not attract tax on the interest earned from the bonds as per Section 10 of the Income Tax Act, 1961.
On the other hand, Tax-Saving Bonds offer tax benefits to the investor by allowing the claim of tax deductions up to Rs 20,000 on investments in government-approved infrastructure bonds under section 80CCF of Income Tax Act,1961.
Q6. What is the pre-tax yield on a tax-free bond trading at 5.5% YTM?
Ans. Assuming tax rates of 10%, 20% and 30% (excluding surcharges for calculation purposes, the pre-tax yield would be as under:
|Pre-Tax Yield for Tax-Free Bonds trading at 5.5%|
|Tax Rate (%)||Pre-Tax Yield (%)|
Q7. How can I redeem my Tax-Free Bonds?
Ans. There are 2 parts to the redemption of these bonds. Firstly, you may sell the bonds on an exchange. The proceeds are credited to your nominated bank account through an automated clearing process in a few working days after the sale. Secondly, the bonds which have completed the tenure may be redeemed from the company issuing the bond. Please note, the issuing company is not permitted to repurchase these bonds prior to their maturity.
Q8. What is the tax payable on the sale of tax-free bonds?
Ans. In case you sell the bond within one year of purchase of the bonds, you would be liable to pay taxes as per your income tax slab. If you hold these bonds for a period exceeding one year, under section 112 of the Income Tax Act, the tax payable on the gains is 10% without indexation, or 20% with the benefit of indexation.
Q9. How can I invest in Tax-Free Bonds?
Ans. When the subscription for fresh bonds is open, an investor may apply online or offline to the issuing company. In the case of previously issued bonds, the investor can open a de-mat account and purchase the bonds on an exchange.