Tax-free bonds benefit long term investors with an income falling in the highest tax slab, like 30%. For instance, if a fixed deposit offering returns at 7%, the interest is fully taxable in the hand of the investor. The interest amount gets added to the investor’s total income, increasing the tax to be paid. Bonds can help high net worth investors (HNIs) from such tax burdens.
What are Tax-free Bonds?
Bonds issued by different public sector entities to raise funds for a specific purpose are generally tax-free bonds. The government utilises the money invested in these bonds in infrastructure projects and housing schemes.
These bonds offer a fixed interest rate and are known as low-risk investment avenues. Returns on most of the government bonds are tax-free under Section 10, Income Tax Act of India. These are the investments with long-term tenor. One example of tax-free bonds is municipal bonds, wherein the issuer is a municipal corporation.
Tax-free Bonds are different from Tax-saving Bonds. Interest income earned on tax-free bonds is not subject to income tax, whereas, in the case of tax-saving bonds, just the initial investment is tax-exempted. Tax-free bonds offer higher returns than tax-saving bonds.
Features of Tax-free Bonds
Issuance and trading
You can invest in tax-free bonds in dematerialised or in physical form. You can subscribe to the issue within the specified time only. These bonds are listed instruments on Stock Exchanges to trade. The liquidity of these bonds may be low. Based on data, 193 series of tax-free bonds are listed to trade on the BSE and NSE. Only 18-20 series are traded with reasonable liquidity, and other series have low volumes. Therefore, it is always better to look for ones whose maturity aligns with your financial goals. Redemption is a simple process once you have reached the bond’s maturity date.
Investors can invest a lump sum amount in a tax-free bond. The lock-in period of tax-free bonds ranges from 10 – 20 years. Investors are not permitted to withdraw the invested capital before maturity. The principal amount is returned to bondholders at the maturity date. They can only trade it on stock exchanges like stocks. The profit on the sale of tax-free bonds is also taxable under Section 112. Therefore, it is better to invest the spare funds you do not need shortly.
The returns on these bonds primarily depend on the purchase price. The bondholder can demand a higher price if the longer his/her money is tied up. Liquidity, maturity and yield to maturity (YTM) are the primary concerns that an investor should consider while investing in tax-free bonds in the secondary markets. The longer the period to bond maturity, the higher the yields.
Reasons to invest in Tax-free Bonds
Following are the reasons that make tax-free bonds one of the most preferred investments:
Tax-free bonds allure more to investors falling in higher tax brackets as these bonds are among the few investments in India where the interest income does not attract tax. The TDS (tax deducted at source) is also not applicable to these bonds. Typically HNIs, HUFs, trusts, institutional investors, cooperative banks prefer tax-free bonds.
Flexibility to Invest
The investor can subscribe to these bonds online or offline. If an investor has missed the subscription dates, he/she can invest through a trading account post-issuance. You can buy/sell these bonds on the stock exchanges before maturity at a discount or premium to their face value. The bond value to trade depends on the interest due date and market conditions.
It rarely happens that these bonds carry default risk. Investors’ principal and interest amounts are safe as they are issued by government-backed enterprises. There is capital protection and assured regular income. Therefore, it can be considered safe to park your funds. Some popular tax-free bond issuers are the National Highway Authority of India (NHAI), Railways, National Bank for Agriculture and Rural Development (NABARD), NTPC Ltd, Indian Renewable Energy Development Agency and many others.
These bonds pay interest annually. The interest rate offered on tax-free bonds generally can go up to 8-9%, which is pretty attractive, along with tax exemption on interest-earning. Interest rates are subject to the prevailing rate of government securities.
Higher Returns Comparatively
Tax-free bonds offer higher returns in comparison to fixed deposits (FDs). Risk-averse investors now have options to park their funds safely for higher returns. They can substitute tax-free government bonds for FDs as the post-tax returns are much better on these bonds.
Compare different options for tax-free bonds with different government entities to find a bond with a maturity as per your financial needs or goals. You can find an investment advisor as your partner in deciding on a profitable portfolio.