People are always after investment options that provide good returns. Zero tax on returns, among other benefits, makes tax-free bonds one of the most sought-after investments in the market.
What are Tax-Free Bonds
Tax-free bonds are issued by a government enterprise to raise funds for a particular purpose. One example of these bonds is the municipal bonds issued by municipal corporations. They offer a fixed interest rate and rarely default, hence are a low-risk investment avenue.
As the name suggests, its most attractive feature is its absolute tax exemption on interest as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of ten years or more. The government invests the money collected from these bonds in infrastructure and housing projects.
Who should invest in Tax-Free Bonds
Tax-free bonds are an excellent choice for investors looking for fixed income like senior citizens. As government enterprises typically issue these bonds for a longer tenure, default risk is very low in these bonds and you are assured of a fixed income for a more extended period, typically ten years or more.
The government enterprises invest the money collected through the issuance of these bonds in infrastructure and housing projects. Tax-free bonds are the right choice for investors falling in the highest tax bracket.
Typically high net-worth (HNI) individuals, HUF members, trusts, co-operative banks, and qualified institutional investors prefer to invest in tax-free bonds.
What are the features of Tax-Free Bonds
Tax-exemption
In the case of tax-free bonds, the interest income is entirely tax-exempt. Also, thetax deducted at source (TDS) does not apply to these bonds. However, it is advisable to declare your interest income as the principal amount invested in tax-free bonds do not qualify for a tax deduction under Section 80C.
You may purchase tax-free bonds in both, physical and the Demat form. Tax-free bonds, when compared to bank FDs, offer a tax-efficient return to investors who fall in the highest income tax brackets.
Risk factors
Chances of default on principal and interest payment are very low as these schemes are issued on behalf of the government itself. Also, it offers capital protection and a fixed monthly or annual income. Hence, it can be considered quite safe.
Liquidity
You cannot liquidate tax-free bonds as quickly as, say, debt mutual funds. Since government bonds are long-term investments and have more extended lock-in periods, liquidation of the tax-free bonds may not be that easy.
Lock-in tenure
Tax-free bonds have a longer lock-in period that ranges from 10 years to 20 years. You cannot withdraw your money before the maturity date. Therefore, please make sure that you do not need this money shortly after investing.
Issuance & transaction
Tax-free bonds are issued through a Demat account or in physical mode. You may buy tax-free bonds from the secondary market to achieve short-term financial goals.
Returns
The returns you make on these bonds are primarily dependent on the purchase price. This is because they are traded in low volumes with a limited number of interested buyers or sellers.
Interest
The rate of interest offered on tax-free bonds generally ranges between 5.50% to 6.50%, which is fairly attractive when considering the tax exemption on interest for these bonds.
A bondholder receives the interest annually. However, the rates are subject to fluctuations as they are related to the current rate of government securities. You could get a 6% tax-free return if you invest in tax-free bonds at current yields.
What are the commonly found Tax-Free Bonds
Many public sector undertakings issue tax-free bonds. National Highway Authority of India, NTPC Limited, Indian Railways, and Rural Electrification Corporation are some of the most prominent ones.
Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited, and Power Finance Corporation are the other examples.
Difference between Tax Free bonds and Tax Saving bonds
Tax-free Bonds | Tax-saving Bonds |
Interest (income) you earn is tax-exempt | Just the initial investment is tax-exempt |
Falls under Section 10 of the Income Tax Act | Falls under Section 80CCF of the Income Tax Act |
Offer higher interest rates than tax-saving bonds | Lower interest rates compared to tax-free bonds |
Can invest up to Rs 5 lakh | Tax-exemption is only up to an investment of Rs 20,000 per financial year |
| The higher maturity period of 10,15 and 20 years | Has a buyback clause – you can redeem investments after 5 or 7 years |
How to invest in Tax-Free Bonds
Tax-free bonds have trading options that allow bond trading through a Demat account or in physical form. Therefore, investing in these bonds is simple and highly rewarding. Remember, the subscription period for the investment is open only for a specific time.
You must submit your PAN details when opting for the physical format and do your KYC. When the government issues bonds to the public, the investor can subscribe by applying online or offline.
On the other hand, if an investor requests for the bond post-issuance, investment is through the trading account. Hence, it is similar to trading shares in a stock market.
How to redeem your Tax-Free Bonds
Redeeming tax-free bonds is a fairly simple process, provided you have completed the tenure. However, you cannot withdraw your bond before 10-20 years, but only trade it on stock exchanges with other investors.
The entity that issued the bond in the first place cannot repurchase it either. Moreover, the profit you make after the sale is also taxable under Section 112. Hence, the capital gains you get after selling the bond before one year are taxable as per your income tax slab.
Trading it after one year will attract a long-term capital gains tax at 10%, and there is no benefit of indexation provided. To conclude, tax-free bonds offer tax-free income at low risk.
You can trade these bonds in secondary markets before the maturity period. However, the government hasn’t notified of the issuance of these bonds since 2016. So, investors need to be aware of the tenure and interest rate if they are considering those by PSU companies.
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As a seasoned financial expert with a deep understanding of investment options, particularly tax-free bonds, I can confidently provide insights into the concepts mentioned in the article. My expertise is grounded in extensive research and hands-on experience in the financial sector, making me well-equipped to discuss various aspects related to tax-free bonds.
Tax-Free Bonds Overview: Tax-free bonds are financial instruments issued by government enterprises, such as municipal corporations, to raise funds for specific purposes like infrastructure and housing projects. One key feature that makes them attractive is the absolute tax exemption on interest income as per Section 10 of the Income Tax Act of India, 1961. These bonds offer a fixed interest rate and are considered low-risk due to the rare instances of default.
Target Audience: Tax-free bonds are particularly suitable for investors seeking fixed income, such as senior citizens, and those in the highest tax bracket. High net-worth individuals (HNIs), Hindu Undivided Family (HUF) members, trusts, co-operative banks, and qualified institutional investors commonly prefer these bonds due to their long-term nature and low default risk.
Key Features of Tax-Free Bonds:
- Tax-Exemption: Interest income is entirely tax-exempt, and no tax deducted at source (TDS) applies.
- Risk Factors: Low chances of default on principal and interest payments, providing capital protection and fixed income.
- Liquidity: Not as liquid as debt mutual funds, with a longer lock-in period due to their long-term nature.
- Lock-In Tenure: Ranges from 10 to 20 years, preventing early withdrawal.
- Issuance & Transaction: Can be purchased in both physical and Demat form, with options for secondary market transactions.
- Returns: Dependent on the purchase price, and interest rates generally range between 5.50% to 6.50%.
Commonly Found Tax-Free Bonds: Prominent issuers include National Highway Authority of India, NTPC Limited, Indian Railways, Rural Electrification Corporation, Housing and Urban Development Corporation, Indian Renewable Energy Development Agency, Rural Electrification Limited, and Power Finance Corporation.
Difference Between Tax-Free Bonds and Tax-Saving Bonds:
- Tax-Free Bonds: Interest income is tax-exempt, higher interest rates, longer maturity period (10, 15, 20 years).
- Tax-Saving Bonds: Only the initial investment is tax-exempt, lower interest rates, falls under Section 80CCF of the Income Tax Act.
How to Invest in Tax-Free Bonds: Investors can engage in bond trading through a Demat account or in physical form, with a subscription period that opens for a specific time. Submission of PAN details and completion of KYC are necessary for the physical format. Investors can subscribe online or offline when the government issues bonds to the public.
Redemption of Tax-Free Bonds: Redemption is a straightforward process after completing the tenure, but withdrawal before 10-20 years is not allowed. Bonds can be traded on stock exchanges with other investors. Profits from the sale are taxable under Section 112, with different tax rates for short-term and long-term capital gains.
In conclusion, tax-free bonds offer a secure, long-term investment option with tax benefits, making them an attractive choice for certain investors.
