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What are Tax-Free Bonds?Tax-free bonds are issued by public sector companies with an aim to raise funds for specific projects. For example, National Highways Authority of India (NHAI) bonds are tax-free in nature and the proceeds are used for infrastructural development of highways in India. Since tax-free bonds are issued by the government, they are extremely safe and carry zero default risk.Apart from the zero risk, the biggest advantage of tax-free bonds is that they provide tax-free income. The interest you earn from tax-free bonds is exempt from tax under section 10 of the Income Tax Act, 1961. When you invest in an ordinary bond or a bank FD, the interest income is added to your income tax slab and tax is levied accordingly. So, if you fall in the highest tax bracket, your interest income is taxed at 30%. But in the case of tax-free bonds, even if you fall in the 30% tax bracket, your tax payable is Nil. Hence, tax-free bonds are extremely popular among high networth individuals (HNIs).
Popular Tax-Free Bonds in 2022Some of the most popular tax-free bonds in 2022 are:
- Indian Railway Finance Corporation Tax-Free Bond
- Power Finance Corporation Tax-Free Bond
- National Highways Authority of India Tax-Free Bond
- Housing and Urban Development Corporation Tax-Free Bond
- Rural Electrification Corporation Tax-Free Bond
- National Thermal Power Corporation Tax-Free Bond
- Indian Renewable Energy Development Agency Tax-Free Bond
- National Bank for Agriculture and Rural Development Tax Free Bond
What are the Advantages of Tax-Free Bonds? – Advantages of Tax-Free Bonds1. Tax-Exempt Interest Income: As the name suggests, the interest earned from tax-free bonds is exempt from tax. Additionally, even tax deducted at source (TDS) is not applicable in case of tax-free bonds.2. Superior Post-Tax Returns: Fixed deposits are a conservative investor’s best friend as they are safe. But in recent years, they have lost their charm. Interest rates on bank fixed deposits have reached an all-time low of 4% in 2021. This is a steep fall from 7.69% just a couple of years back. Now imagine if you fall in the 30% tax bracket. Your real post-tax rate of return dropped from 4% to a meagre 2.8%.In contrast, tax-free bonds provide anywhere between 5.5-6.5% rate of return. Since no tax is levied on this interest income, your actual returns are 5.5-6.5%. While FD interest rates have fallen to 4%, tax free bonds like RECNF provide as high as 8.88% rate of interest.3. Long-Term Lock-in Period: Tax-free bonds are suitable for investors with a long investment horizon as their lock-in period ranges from 10 to 20 years or more. For example: Power Finance Corporation Tax-Free bond was first issued on 15th October 2011. The tenure of the bond is 15 years and it will mature on 15th October 2026. So, if you are a long-term investor, then tax-free bonds generate superior tax-adjusted returns compared to bank FDs and ordinary bonds.4. Zero Default Risk: Tax-free bonds are issued by public sector undertakings. Hence tax-free bonds are extremely safe and carry zero default risk unlike other bonds. So, investors get the comfort of staying invested for the long-term as their principal and interest repayment is assured.5. Helps Save Tax on Sale of Property: Apart from providing tax-free interest income, tax-free bonds also help you in saving tax on house property. When you sell a property, you incur long term capital gains tax (assuming you sold the property after three years). You can either pay a flat 20% capital gains tax or you can invest the capital gains amount in REC or NHAI tax-free bonds. The maximum investment in these bonds is Rs 50 Lakhs under section 54EC. These bonds have a compulsory lock-in period of five years.Let us now take a look at the disadvantages of Tax-free bonds. Yes, even though they provide tax-free interest income, tax-free bonds have the following disadvantages.
What are the Disadvantages of Tax-Free Bonds? – Disadvantages of Tax-Free Bonds1. Low Liquidity: While tax-free bonds are listed on stock exchanges, they have limited liquidity. Imagine you have invested in Power Finance Corporation Tax-Free Bond in 2011. In 2021, you have an emergency and want to redeem from the bond. Since the bond will mature in 2026, you cannot sell it back to the issuer. Your only way out is to sell it to another bond investor via the stock exchange. But since these bonds have very little liquidity, finding buyers and sellers is extremely tough. Hence, the biggest disadvantage of tax-free bonds is its limited liquidity.2. No Collateral: Sovereign gold bonds and other bonds can be kept as a collateral against loans. But Tax-free bonds are not accepted by banks as a collateral against loans. Hence, investors cannot leverage them to take loans.3. Limited Tax Benefit: When you invest in equity linked savings scheme (ELSS), the investment amount is allowed as a deductible under section 80C. However, in case of tax-free bonds, the principal amount does not qualify for any deduction.
Tax Free Bonds and Credit RatingWhile tax-free bonds experience very little default risk, it is nevertheless recommended to study their credit rating before investing. Tax-free bonds are rated by credit rating agencies on a scale of AAA to D.
- Low credit rating implies higher risk and these tax-free bonds generally provide higher interest rate.
- High credit rating implies low risk and such tax-free bonds provide comparatively lower interest rate.
|AAA||Low credit risk and highest degree of safety|
|AA||Low credit risk and a high degree of safety|
|A||Low credit risk and adequate degree of safety|
|BBB||Moderate credit risk and a moderate degree of safety|
|BB||Moderate risk of default|
|B||High risk of default|
|C||Very high risk of default|
|D||The security has already defaulted or is expected to be in default soon|
Trading in Tax-Free Bonds in Secondary MarketTax free bonds are issued in the primary market but they are traded in the secondary markets. If you wish to buy bonds, you can purchase pre-issued bonds from the stock exchanges – National Stock Exchange (NSE) or Bombay Stock Exchange (BSE). But remember to analyse the bonds yield to maturity.
What is Yield to Maturity (YTM)?YTM is the total returns earned by an investor if he purchases the bond from the secondary market and holds them till maturity. As tax-free bonds are traded in the secondary markets, their coupon rate keeps fluctuating.For example, what will the coupon amount be if a bond with a face value of Rs 1,000 offers a coupon rate of 8% per annum? The answer is Rs 80 (1,000*8%).If the company issues a new bond with an interest rate of 9% then most people are likely to sell the old bond and purchase the new bond. Hence, the price of the old bond decreases and it is available at Rs 900. Discount of Rs 100. But the coupon amount earned by the investors is still Rs 80.However, the yield to maturity is now 8.88% (80/900*100).
- If a bond is available at a discount to its face value, then its YTM will increase.
- If the price of the bond is available at a premium to the face value, then its YTM will decrease.
How are Tax-Free Bonds Taxed? – Tax Implications on Tax-Free Bonds
- The interest you receive from tax free bonds is tax-free if you hold your bond till maturity. So, there is no concept of tax deducted at source (TDS).
- But if you sell the bonds in the secondary market, your transactions will be subject to tax.
- If you sell your bond in the secondary market after 12 months, the gains are taxed at 10%.
- If you sell the bond in less than 12 months, then the capital gains are taxed as per your income tax slab.
- Tax free bonds are recommended to individuals who fall under the high tax brackets.
|Rishi’s investment in fixed deposit||Ram’s investment in tax free bonds|
|Annual Income||Rs 15,00,000||Rs 15,00,000|
|Initial investment||Rs 1,00,000||Rs 1,00,000|
|Interest earned from investment||Rs 6,000 (6% of Rs 1,00,000)||Rs 5,500 (5.5% of Rs 1,00,000)|
|Taxable income||Rs 15,06,000||Rs 15,00,000|
|Tax payable on interest earned at 30%||Rs 1,800 (30% of Rs 6,000)||–|
|Post-tax return (in Rs)||Rs 4,200||Rs 5,500|
|Post-Tax return (%)||4.2%||5.5%|
How to Invest in Tax-Free Bonds in India?You can easily invest in tax free bonds online (through a Demat account) or offline. The subscription period for the bond is short. So, investors have to subscribe to tax-free bonds in the stipulated time.If you want to invest by submitting a physical application, then these are the documents required:
- PAN card details
- Bank details – Account number and IFSC code.
3 Most Popular Tax-Free Bonds in India1. 8.46% REC N6 Tax Free Bonds
- Coupon rate: 8.46%
- Issuing company: Rural Electrification Corporation Limited (REC)
- This bond was issued by the Rural Electrification Corporation of the N6 series in 2013 and will mature in 2028.
- It is traded on the National Stock Exchange.
- The current yield provided by the bond is 5.75%.
- The bond is AAA rated and hence is a safe investment option.
- Coupon rate: 8.20%
- Issuing company: The Housing and Urban Development Corporation Limited (HUDCO).
- This bond was issued by HUDCO of N2 Series in 2012 and will expire in 2027.
- This bond is also listed on NSE.
- The current yield provided by the bond is 3.24%.
- Coupon rate: 8.20%
- Issuing company: National Highways Authority of India
- Maturity: 25th January 2022
- Coupon frequency: Once a year
- Credit rating: AAA-rated
- Listed on: NSE and BSE
Who Should Invest in Tax-Free Bonds?
- Tax-free bonds are an excellent choice for retired individuals who are looking for fixed income. Tax-free bonds are 100% safe and provide tax-free interest income. However, since they have a long-term lock-in period, retirees should exercise caution.
- Investors in the highest tax bracket, looking to earn fixed returns for long-term (10 to 15 years) can invest in tax-free bonds.
- Individuals who have recently sold a house property and wish to save capital gains tax can invest in tax-free bonds up to Rs 50 lakhs under section 54EC.