Tax-Free Bonds

This article talks about everything you need to know about tax-free bonds.

Investors are always looking for investment options with higher returns. Most individuals including senior citizens who wish to invest in debt securities should look for tax-efficient investment instruments. Tax-free bonds are one such instrument, which is low risk, pay regular interest, have long tenure, are liquid, and most importantly offer tax-free returns. These characteristics of tax-free bonds make it one of the most sought-after investment options in the financial market.

Tax-Free Bonds: An Overview

Tax-free bonds are debt instruments, issued by a government enterprise to raise funds for specific purposes. Commonly tax-free bonds are offered by Public Sector Undertakings (PSU) such as NTPC, NHAI, REL, etc. In simple words, investors are lending money to these enterprises and in return, these enterprises promise to pay certain fixed interest to investors until maturity. The annual interest is known as a coupon in the bond market. As the name suggests, the interest earned on tax-free bonds is exempt from taxes in the hands of the investor under section 10 of the Income Tax Act,1961. Normally, these bonds are redeemable, non-convertible, and secured in nature. These bonds are also traded in the secondary markets i.e., on stock exchanges. Tax-free bonds have a long-term maturity period of 10 or more years.

Features of Tax-Free Bonds

  • Interest Rates: Bondholders receive interests on tax-free bonds on an annual basis. The interest rates are subject to fluctuations as they are correlated to the current rate offered on government securities. Interest rates may also vary depending upon different issuers and tenures. Currently, you may expect to get rates around 5.75-9% on tax-free bonds. Along with the interest rates, these bonds also provide the tax benefit, which should be considered by the investors.
  • Lock-in Period: Tax-free bonds have a lock-in period that may range between 10 to 20 years. Thus, the amount invested in these bonds cannot be withdrawn by bondholders before the expiry of the applicable lock-in period. Investors should make sure that they will not be requiring this money shortly after the investment.
  • Liquidity: Although tax-free bonds are listed on the stock exchange, their liquidity is a concern as the trading volume of these bonds is usually very less. Bondholders may have to compromise on the bond price if they wish to sell their bonds before maturity. These bonds are less liquid than debt mutual funds.
  • Tax Exemption: The interest income on tax-free bonds is entirely tax-exempt. Additionally, no TDS is applicable to these bonds. However, the principal amount invested in tax-free bonds is not eligible for deduction under the IT Act, 1961. Also, any capital gain received by selling these bonds in the secondary market is taxable.
  • Risk Factors: The risk of non-payment or credit risk is very low for tax-free bonds as these are issued on the behalf of the government. Tax-free bonds also offer regular fixed income and capital protection, and hence are considered a safe investment option.
  • Bond Yield: Bond yield may be different from the coupon rate. The bond yield is calculated on the purchase price, whereas coupon rates are on face value. If an investor purchases tax-free bonds from the secondary market, the purchase price may not be equal to the face value of the bond. For any investor, bond yield is very significant as it is the return that they will receive by investing in the bond.
  • Issuance & Investment: Tax-free bonds are issued in two forms i.e., Demat Account or in physical mode. Investors can invest in these bonds either through the primary market or the secondary market.
  • Redemption: If the investors hold their bonds till maturity, the bonds shall be redeemed by the issuing enterprises at the predetermined value. However, investors cannot withdraw their bonds before maturity, they can only trade these bonds on the stock exchanges with other investors.

Who should invest in Tax-Free Bonds?

First, let us look at categories of investors who can invest in tax-free bonds:

  • Retail individual investors including members of HUF and NRIs.
  • High Net-Worth Individuals (HNIs), who can invest up to Rs. 10 lakhs.
  • Qualified Institutional Buyers
  • Partnership firms, LLPs, trusts, cooperative banks, corporates, and other entities authorized by the law.

Tax-free bonds are well suited for investors with low and modest risk tolerance. These bonds also attract HNIs looking for a steady source of income. Tax-free bonds are also an excellent choice for senior citizens looking for fixed income sources along with capital protection. These bonds are generally recommended to investors who can afford to lock in their capital for longer time periods. A tax-free bond is highly recommended to individuals falling under the highest tax bracket.

How to Invest in Tax-Free Bonds

Investors can invest in tax-free bonds through their Demat account or in physical form. In the case investors opt for physical form, they need to furnish their PAN and the process of KYC is carried. When government enterprises issue bonds to the public, the investors can subscribe to them by applying either online or offline. Investors can also invest in tax-free bonds through stock exchanges post their issuance through their trading account.

Tax-Free Bonds Vs. Tax-Saving Bonds

Basis Tax-Free Bond Tax-Saving Bond
Tax Benefit Under section 10 of the IT Act, 1961, the interest income is exempt. Under section 80CCF of the IT Act, 1961, only the initial investment is tax-exempt.
Returns These bonds offer higher returns as compared to tax-saving bonds. These bonds carry lower returns in comparison to tax-free bonds.
Maturity These bonds have a higher maturity period of more than 10 years. But they can also be traded on the stock exchanges. These bonds usually have a buyback clause and thus investors can redeem their investments after 5 or 7 years.
Exemption Limit Investors can invest up to Rs. 5 lakhs in tax-free bonds and all interest income are exempt from tax. Tax exemption is allowed only up to an investment of Rs. 20,000 per financial year.
Suitability Tax-free bonds are suitable for conservative retirees or senior citizens looking for regular income sources. It is also suited for other investor categories like HUFs, HNIs, qualified institutional investors, etc. Tax-saving bonds are generally suitable for medium or long-term investors.