What are tax-free bonds and how they work

Here’s everything you need to know about tax-free bonds and how to choose the best bonds to add to your portfolio

What are tax-free bonds and how they work

Indian investors seem to be spoilt for choice when it comes to investing. From investment schemes offering monthly, quarterly, half-yearly as well as annual returns, to schemes offering taxable as well as non-taxable returns, the list is endless. Choosing the right investment avenue, therefore, may not be as easy as it appears. One of the hugely-popular investment options, especially among high net worth investors, are tax-free bonds. Let's take a look at what are tax-free bonds, how they work and how to choose the best tax-free bonds that you could add to your portfolio.

What are tax-free bonds? 

Tax-free bonds are a fixed income instrument carrying a coupon rate of interest and is issued for a fixed tenure. As the name suggests, interest earned from tax-free bonds is exempt from tax. In simple terms, irrespective of the income slab one need not pay any income tax on the interest income. Some of the public undertakings which raise funds through the issue of tax-free bonds in India are IRFC, PFC, NHAI, HUDCO, REC, NTPC, and Indian Renewable Energy Development Agency.

The tenure of tax-free bonds is usually 10/15 or even 20 years. They are also listed on stock exchanges to offer an exit route to investors. The bonds are tax-free, secured, redeemable and non-convertible in nature.

Tax status

The interest income earned from tax-free bonds is exempt from tax under Section 10 (15) (iv) (h) of the Income Tax Act, 1961. There will, however, not be any tax benefit on the amount of investment made in such bonds. Also, there is no applicability of TDS on interest income. TDS will still be payable on the application money while subscribing to the tax-free bonds.

Such bonds are also listed on stock exchanges and traded only through demat accounts. If there is any capital gain on transferring them on exchanges that will be taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the applicable tax slab of the investor. If bonds are held for more than 12 months, the gains are taxed at 10.3 per cent. There will not be any benefit of indexation on the sale of such tax-free bonds.

Related: Tax benefits after retirement

The pluses

Tax-free bonds are hugely popular with high net worth investors because they allow parking a huge lump sum at one place. They are perceived to be relatively safe as they are primarily issued by government institutions and carry high investment grade ratings. Also, the effective pre-tax yield is high for those in the higher income slab. Although tax-free bonds are low-risk products, the effective pre-tax yield appears to be high. Anil Rego, CEO & Founder, Right Horizons says, "If we look at tax-free bonds from financial planning per se, though it is a low-risk asset class but even an investor with a high-risk profile can invest in them because the returns are tax-free and hence if worked backwards, then the post-tax returns would be quite high. This enables an investor to not only earn tax-free income but also ensure safety of capital."

Suits those in higher tax slab

The tax-free nature of bonds suits those in the highest tax slab paying 30 percent tax on their income (excluding surcharge and cess). Say, a bank deposit carries 7.5 per cent return on it. As the interest on fixed deposit is fully taxable, the income gets added to one's total income. Therefore, for someone paying 30 percent tax, the net income will be 5.25 percent, a tad higher than what savings accounts offer.

What it means 

It means for someone paying tax of 30 percent, investing in a taxable investment yielding not less than 8.58 percent return will make sense. A taxable investment yielding 8.58 percent return will fall to 6 percent post-tax of 30 percent. However, in reality, bank deposits currently are offering around 7.4 percent (taxable) return even on deposits of ten years. Even someone paying 20 percent tax may find these tax-free bonds suitable.

How they work

The interest that an issuer can offer to investors depends on the yield of government securities prevailing around the time of issuance. Once set and offered, it will remain fixed for the entire tenure. The interest rate will depend on two factors - One, on the ratings of the issuer and secondly, whether the investor is a retail or a high net worth investor.

The best tax-free bonds in India are rated as AAA. The interest rate for retail investors will be 0.5 per cent lower than the G-sec rate and 0.8 per cent lower for all other investors. For tax-free bonds rated AA+, the interest rate will be 0.10 per cent higher than AAA-rated issuers and for tax-free bonds rated AA or AA-, the interest rate will be 0.20 per cent higher than AAA-rated issuers.

Retail individual investor is one who is investing up to Rs 10 lakh in each issue, including NRI's (on repatriation or non-repatriation basis), while those investing above Rs 10 lakh are considered high net worth individuals.

The minuses

The tenure of tax-free bonds being long term, one should carefully invest in them keeping intermittent goals in mind. Invest in them only if you are sure you would not require the funds for a long period. 

Liquidity is low in tax-free bonds. Usually, they are listed on stock exchanges to provide an exit route to investors. Price and volume may play a spoilsport while off-loading them.

Further, frequency of interest payment in tax-free bonds is generally on an annual basis. For half-yearly interest payment, the rate is generally reduced by 0.15 percent. Unless interest income is put to good use, by say, diverting it towards long-term market-linked investments, the entire tax-free investment may not yield optimum result. Rego says, "In case one has opted for a cumulative interest payout, i.e. payouts along with the capital on maturity, the same can be utilised to meet the required goal."

Conclusion

Tax-free bonds may not be ideal to create wealth in order to meet long-term goals such as child education, marriage or retirement. They primarily help minimise ones tax liability. Therefore, invest in them after properly evaluating your tax bracket, tax liability and long-term needs.

(Readers are advised to consult their tax advisor for detailed advice.)

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