- Date : 17/08/2023
- Read: 10 mins
Most HNIs, senior citizens, and other individuals who wish to invest in debt securities are always looking for tax-efficient investment products. Tax-free bonds are one such investment option as they are safe, have a long tenure, pay regular interest, are tradable on exchanges – and most importantly, provide tax-free interest. In this article, we list the best tax-free bonds for investment.
Are you a senior citizen or high networth individual or fall in the highest income tax bracket and are looking to invest in debt securities? If yes, you should consider tax-free bonds. If you are looking to invest for a long tenure of 10 years or more, you can consider buying bonds of HUDCO (NE series), PFC (N8 series), or IIFCL (N4 series). These bonds have a remaining tenure of 12-13 years.
If you are looking to invest for a lower tenure of under 10 years, you can consider buying bonds of REC (NI series), IREDA (N7 series), NABARD (N2 series), or HUDCO (ND series). These bonds have a remaining tenure of 6-10 years.
Here are some of the top-performing Tax Free Bonds you must invest in August 2023. These include National Hydro Power Corporation, which gives you a coupon rate of 8.92%, Power Finance Corporation Limited that provides a coupon rate of 8.92%, India Infrastructure Finance Company Limited with a coupon rate of 8.91%, India Renewable Energy Development Agency Ltd that allows for a 8.80% coupon rate, etc.
Here are some of the top-performing Tax Free Bonds you must invest in September 2023. These include National Hydro Power Corporation, which gives you a coupon rate of 8.92%, Power Finance Corporation Limited that provides a coupon rate of 8.92%, India Infrastructure Finance Company Limited with a coupon rate of 8.91%, India Renewable Energy Development Agency Ltd that allows for a 8.80% coupon rate, etc.
Best tax-free bonds for investment in November
Tax-free bonds – some FAQs
1) What are tax-free bonds?
Tax-free bonds are debt instruments that are usually issued by Public Sector Undertakings (PSUs). A PSU accepts money from investors for a specified time and, in return, issues the tax-free bond and promises to repay the money at the end of the bond tenure. It also promises to pay a specified annual interest rate during the bond tenure. The company redeems the bond and credits the maturity proceeds to the investor’s bank account on the maturity date.
2) What are the features of tax-free bonds?
Tax-free bonds have the following features:
Issued at face value: These bonds are usually issued at a face value of Rs 1000. In other words, to purchase one unit of the tax-free bond at the time of issuance you have to pay Rs 1000.
Coupon rate: The bonds have a coupon rate. For example, Power Finance Corporation (PFC) issued N6 series of bonds at a coupon rate of 8.43% p.a. It means the bond will pay an annual interest rate of 8.43% to the bondholders. The interest is paid either semi-annually or annually, as specified at the time of bond issuance.
Tenure: The bonds are issued for long tenures of more than 5 years, and go up to 20–30 years. An investor can hold them till maturity. These bonds are tradeable on the stock exchanges like NSE and BSE. So, if the investor needs money before maturity, they can sell the bonds through the stock exchange.
3) How is the interest earned on tax-free bonds exempt from tax?
The most appealing feature of tax-free bonds to investors is that the interest earned on these bonds is tax-free. This is made possible under Section 10 of the Income Tax Act. Since the interest paid is tax-free in the hands of the investors, those in the highest tax bracket looking to invest in debt securities prefer to invest in these bonds.
4) What is the risk with tax-free bonds?
Tax-free bonds are usually issued by PSUs, where the majority shareholder is the union government. So, the risk of default is very low. Liquidity can be an issue, however. The trading volumes are low in the case of some of these bonds. If you wish to sell them on the exchange, you may sometimes find it difficult to get a buyer. Even if you find a buyer, you may not get the desired price.
5) What is the process of buying tax-free bonds?
You can buy tax-free bonds in two ways. You can either apply for the bonds when the company comes up with a new bond issue, or buy already issued and listed bonds from another bondholder who wants to sell through the stock exchange.
While applying for a bond during a new issue, you can apply in physical format or demat format. But for buying and selling bonds through the secondary market, you need a trading and demat account. For buying the bonds, you have to place a buy order from your trading account. At the time of clearing and settlement, the bonds will be credited to your demat account. Similarly, for selling the bonds, you have to place a sell order from your trading account. At the time of clearing and settlement, the exchange will debit the bonds from your demat account.
If you hold the bonds until maturity, the bonds will be redeemed by the issuing company, and the redemption amount will be credited to your bank account.
6) What are the taxation aspects of tax-free bonds?
As an investor, you need to understand the following phases of a bond for taxation purposes:
At the time of issuance: Some financial products qualify for deduction from taxable income at the time of investment or issuance. However, please note that tax-free bonds don’t qualify for any tax deduction at the time of investment or issuance.
Annual interest earned on the bond: The annual interest earned on tax-free bonds is exempt from taxation under Section 10 of the Income Tax Act. So, as an investor, the interest you earn on these bonds is tax-free in your hands. There is no tax deducted at source (TDS) on the interest earned on these bonds.
Capital gains: If you sell the tax-free bond before maturity, there will either be a capital gain or a capital loss depending on the price at which you bought and sold the bonds. Also, depending on the holding period of the bond, the capital gain will be classified as either a short-term capital gain or long-term capital gain. Capital gains, whether short-term or long-term, are taxable if earned from a tax-free bond.
Maturity proceeds: If you hold the bond till maturity, it will be redeemed by the company at face value (the price at which you bought the bond from the company). Hence, there will be no capital gain on redemption at maturity. As there is no capital gain, there will be no capital gain tax.
7) Who should invest in tax-free bonds?
Investors looking to invest in debt securities that give tax-free interest income should invest in tax-free bonds. Senior citizens, high networth individuals (HNIs), and others falling in the highest income tax bracket can look at tax-free bonds. These bonds have a long tenure of usually more than five years and hence ensure a fixed, regular, tax-free income for a long time.
From a taxation point of view, tax-free bonds are more tax-efficient as compared to bank fixed deposits. The interest earned on a bank fixed deposit is taxable, whereas the interest earned on tax-free bonds is exempt from taxation.
8) Which are the companies that issue tax-free bonds?
Here is a list of some companies that issue tax-free bonds:
National Bank for Agriculture and Rural Development (NABARD)
India Infrastructure Finance Company Ltd (IIFCL)
Housing and Urban Development Corporation Ltd (HUDCO)
Power Finance Corporation (PFC)
Rural Electrification Corporation (REC)
Indian Renewable Energy Development Agency Limited (IREDA)
Tax-free bonds traded on NSE
9) What should an investor keep in mind while buying bonds from the secondary market?
The price at which the bonds are traded in the secondary market is different from the face value at which the company issued the bonds. The bond’s market price depends on the movement of market interest rates after the bond was issued.
Bond prices and interest rates have an inverse relation. So, if market interest rates move up, bond prices will move down. If market interest rates move down, bond prices will rise. In the current year (2021) and last year (2020), no new tax-free bonds were issued by any company. Also, after the COVID-19 impact on the economy, the RBI has cut interest rates in FY 2020-21. So, as interest rates move down, the market prices of all bonds issued before 2020 have moved up.
As of July 2021, all tax-free bonds issued before 2020 at a face value of Rs 1000 are trading at a market price ranging from Rs 1085 to Rs 1500. The market price depends on factors like when the bond was issued, the coupon rate at which it was issued, the time left for maturity, the price expectation of the seller, etc. So, while buying tax-free bonds from the secondary market, you should keep the above factors in mind.
When you buy tax-free bonds from the secondary market, the annual interest paid to you will be as per the coupon rate. However, your actual return will depend on the market price that you have paid to purchase the bond.
For example, REC Limited issued a tax-free bond (NH series) with a face value of Rs 1000 with a coupon rate of 7.43% p.a. Suppose you bought the bond in July 2021 at a market price of Rs 1325. The annual interest the company will pay you will be Rs 74.3 (7.43% p.a. on the face value of Rs 1000). However, while calculating your actual annual return, you will have to calculate a return of Rs 74.3 on an investment of Rs 1325 (bond market price). So, your return will be 5.61% p.a.
10) Most tax-free bonds are currently trading at a premium vis-a-vis their face value. Will this continue in the future also?
In FY 2020-21, the RBI cut interest rates drastically to multi-year lows to help the Indian economy recover from the slump induced by COVID-19. Due to the cut in interest rates, the prices of most bonds have gone up and are trading at a premium compared to their face value.
As of July 2021, the interest rates seem to have bottomed out. The RBI has held interest rates steady from the last few months. In the future, the RBI is expected to normalise liquidity and then go for gradual interest rate hikes. Once interest rates start rising, bond prices are expected to fall due to their inverse relationship with interest rates.
Once the market interest rates exceed the coupon rate at which the bond was issued, the bond's market price will fall below the face value of Rs 1000. When the bond market price falls below the face value, the bond is said to be trading at a discount to the face value.