Bonds are financial securities issued by companies and governments in order to raise capital. For investing their assets, prospective investors earn returns based on a predetermined interest rate. Tax-free bonds are advantageous investments for individuals, trusts, HUFs, etc. because they are exempt from taxation.
What Are Tax Free Bonds?
Government-owned company issues tax-free bonds. They offer a set rate of interest. Consequently, they are seen as a low-risk investment. They have ten-year or longer terms connected to them. However, they can be traded on the stock market. The tax on returns is entirely exempt from taxation. In accordance with Section 10 of the Income Tax Act, these bonds are totally tax-exempt.
Typically, tax-exempt bonds have a face value of INR 1,000. They carry a coupon rate, which is the rate of interest paid to investors. Interest is paid semiannually. When these bonds are traded on a stock exchange, their market price is significant. If interest rates decline, bond prices will rise and they will trade above face value.
If a bond is acquired at face value and kept to maturity, the coupon rate equals the bond yield. Bond yield is the return earned by investors. However, bonds are exchanged, therefore it is possible for interest rates to fluctuate. If the bond’s market price increases, the interest rate decreases. When the market price of a bond decreases, interest rates increase. They have an inverse relationship.
How do Tax-Free Bonds Work?
Government entities that wish to raise funding for specific capital expenditures issue tax-free bonds. The issue remains open for a limited period. Investors can purchase these bonds by subscribing to the offering.
These bonds, like other bonds, offer fixed interest as a return to investors. The interest rate is decided by the yield on government securities when they are issued, the credit ratings of the issuer, and the qualification of investors, i.e. whether they are retail investors or high-net-worth individuals (HNIs). Investors who invest less than or equal to Rs. 10 lakh in an issue are considered retail investors, whereas investors who invest Rs. 10 lakh or more in an issue qualify as HNIs.
Typically, tax-free bonds have maturities of 10, 15, or 20 years. At maturity, bondholders may redeem their tax-free bonds. Investors can also purchase and sell these bonds on the secondary market, post-issuance and prior to maturity. If the bondholder sells the bond before one year, the profit is subject to income tax according to the applicable tax bracket. If the bondholder sells it after one year, their earnings will be subject to a 10% tax on long-term capital gains, with no indexation benefits.
In conclusion, tax-free bonds exempt investors from paying taxes on the interest income they obtain. They offer favourable profits while avoiding risk. Due to their lengthy maturities, however, the liquidity of such bonds is weaker. However, these bonds are more appropriate for investors who prefer less risk and are willing to remain invested for a longer period of time.
What are the features of Tax-Free Bonds?
- Risk: As they are backed by the government, the risk associated with these bonds is quite low. Therefore, the likelihood of default is low, and they can give stable and reasonable monthly returns.
- Tax exemption: Interest earned on these bonds is entirely exempt from taxation. In addition, the bonds do not have a TDS clause, meaning that the issuer is not required to deduct tax at the source prior to crediting interest to the recipient’s bank account. However, the invested principle is not eligible for deductions under section 80C.
- Lock-in Period: Tax-exempt bonds have a specified maturity period. The duration spans from 10 to 20 years and investors are unable to withdraw funds before the bond matures. Individuals must ensure that they will not require the funds they invest in the near future. Note, however, that the bonds are tradable on stock exchanges.
- Liquidity: The bonds are less liquid than alternative investment instruments. Due to the fixed lock-in term associated with these instruments, investors cannot withdraw funds prior to maturity. Therefore, liquidating them may be difficult.
- Issuing authority: These bonds can only be issued by government-owned companies and municipal corporations. If investors are unable to purchase these bonds during the subscription period, they may do so on secondary markets in order to satisfy their financial objectives.
- Interest: Annually, investors can earn a guaranteed interest rate on their bond investments. The prevailing rate of government securities influences the interest rate environment. An investor can earn a better rate of return compared to a savings account. Taking into account the tax-exempt status, it becomes an economical investment strategy.
What are the Advantages of a Tax Free Bond?
- Interest Income Exempt From Taxation: Interest income exempt from taxation. As the name implies, the interest earned on these bonds is not subject to taxation. In the case of tax-free bonds, even tax deducted at source (TDS) is not applicable.
- Better Post-Tax Return: Fixed deposits are the most reliable investment option for conservative investors. In recent years, however, they have lost their allure. In 2021, bank fixed deposit interest rates reached an all-time low of 4%. This is a significant decline from 7.69% just a few years ago. Imagine now that you are in the 30% tax bracket. Your true after-tax rate of return fell from 4% to a pitiful 2.8%. In comparison, tax-free bonds offer a rate of return between 5.5% and 6.5%. Since this interest income is not subject to taxation, your actual returns are between 5.5% and 6.5%. While FD interest rates have plummeted to 4%, tax-free bonds such as RECNF provide rates as high as 8.88%.
- Lock-in Period: As their lock-in term extends from 10 to 20 years or more, these bonds are excellent for investors with a long investment horizon. For instance: The first Power Finance Corporation tax-exempt bond was issued on October 15, 2011. The bond has a 15-year term and will mature on October 15, 2026. Therefore, if you are a long-term investor, these bonds offer higher post-tax returns than bank FDs and conventional bonds.
- Zero Default Risk: Public sector corporations issue tax-free bonds. In contrast to other bonds, these bonds are exceptionally secure and bear almost no default risk. As a result, investors are certain of receiving their principal and interest payments over the long term.
- Helps Reduce Taxes on Property Sales: In addition to delivering tax-free interest income, these bonds can help you save on property taxes. When you sell a home, you are subject to long-term capital gains tax (assuming you sold the property after three years). You can either pay a 20% flat capital gains tax or invest the capital gains amount in tax-free REC or NHAI bonds. Under section 54EC, the maximum investment in these bonds is Rs 50 lakhs. These bonds have a five-year mandatory holding term.
What are the Disadvantages of Tax-Free Bonds?
- Liquidity: Although tax-exempt bonds are listed on stock exchanges, their liquidity is limited. Imagine that in 2011 you invested in the Power Finance Corporation Tax-Free Bond. You have an emergency in 2021 and wish to redeem the bond. Due to the maturity date of 2026, you cannot sell the bond back to the issuer. Your sole option is to sell the bond on the stock exchange to another bond investor. However, as a result of the low liquidity of these bonds, it is incredibly difficult to locate buyers and sellers. Consequently, the greatest drawback of tax-free bonds is their low liquidity.
- No Collateral: Loans may be secured with sovereign gold bonds and other bonds. However, in general, banks do not accept these bonds as collateral for loans. Therefore, investors cannot use them as collateral for loans.
- Limited Tax Benefit: When you invest in an equity-linked savings plan (ELSS), the amount of your investment is tax deductible under section 80C. In the case of tax-exempt bonds, however, the principal amount is not eligible for a deduction.
Who should invest in Tax-Free Bonds?
Investors seeking a fixed income, such as older folks, can invest in these bonds. In addition, investors seeking to invest a lump sum in an asset with absolute returns might invest in tax-free bonds. Because the government guarantees these bonds, the risk of default is reduced. In addition, the maturities of these government-issued bonds range from ten to twenty years. Moreover, these government bonds provide a set income. To finance initiatives such as housing and infrastructure, the government may issue tax-free bonds to raise funds.
Tax-free bonds are most appropriate for retail investors in the highest income tax bracket who seek tax-free income. Individuals with a high net worth, institutional investors, HUFs, cooperative banks, and trusts may consider these as an investment options. These bonds can be traded either physically or via a Demat account. Investing in such bonds is simple, and guaranteed returns are available.
What are the Commonly Found Tax-Free Bonds?
Here is the list of commonly found tax-free bonds:
- Rural Electrification Corporation Tax-Free Bond
- National Thermal Power Corporation Tax-Free Bond
- Housing and Urban Development Corporation Tax-Free Bond
- National Highways Authority of India Tax-Free Bond
- National Bank for Agriculture and Rural Development (NABARD) Tax-Free Bond
- Indian Railway Finance Corporation Tax-Free Bond
- Power Finance Corporation Tax-Free Bond
- Indian Renewable Energy Development Agency Tax-Free Bond
How To Invest In Tax-Free Bonds?
When the government issues a new offering of tax-free bonds, investors can choose between online and offline options. The duration of this bond’s subscription is brief. Therefore, investors must subscribe within the allotted time frame. In addition, PAN card details and bank information, including account number and IFSC code, are required when investing offline (in physical form).
Also, if an investor desires to invest in these bonds after the date of issuance, they can do so through a trading account. Therefore, following the issuance, it is comparable to trading on the stock market.
How to Redeem Your Tax-Free Bonds?
Tax-free bonds have a predetermined maturity date. Redeeming such bonds is a rather straightforward process, assuming the term has expired. However, you cannot redeem your bond until 10 to 20 years have passed; you can only trade it on stock exchanges with other investors.
The entity that originally issued the bond is unable to repurchase it as well. Additionally, under Section 112, your profit from the sale is taxable. Therefore, capital gains realized from the sale of a bond within the first year are subject to taxation based on your income tax bracket.
After one year, it is subject to a 10% long-term capital gains tax, and no indexation advantage is offered. In conclusion, tax-exempt bonds provide tax-free income with little risk on maturity. Before the maturity period, these bonds can be traded on secondary markets. Therefore, investors who are considering bonds issued by PSU businesses must be aware of the maturity and interest rate.
Conclusion
Tax-free bonds provide a tax-free fixed income. These are investments with low risk. They are suited for HNWIs, HUF members, and trusts, among others. They are moderately liquid since they can be traded on the stock market (secondary market). The principal amount is ineligible under any section of the Income Tax Act for tax savings. In addition, the maturities of these government-issued bonds range from ten to twenty years. These can be considered by HNWIs, institutional investors, HUFs, cooperative banks, and trusts as one of their investment alternatives. However, before investing in them, one must analyze and evaluate their lengthy maturities, interest rates, and tax advantages.
FAQs
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How safe are these tax-free bonds?
Tax-free bonds are a generally secure kind of investment. The government-backed entities guarantee these obligations. Therefore, the likelihood of default is relatively very low. They are appropriate for risk-averse investors seeking to diversify their portfolios.
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What are municipal bonds?
Municipal bonds are issued by local governments for various social welfare goals. Municipalities utilize these financial instruments to raise funding for the construction of hospitals, schools, and drinking water facilities.
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Is a minor eligible for these tax-free bonds?
No, minors are not eligible.
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