Tax-Free Bonds: What are they, features and whom do they suit

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There is no upcoming tax-free bonds issue in the market, but you may invest in these bonds which are listed on the stock exchanges.

Many investment options such as bank fixed deposits, SCSS, post office monthly income plan, and PMVVY, among others, have a thing in common. The interest income earned from them is taxable in the hands of the investor in the year of receipt. Do you want to invest in a fixed income instrument and not pay any tax on the interest income? Yes, it is possible if you are buying tax-free bonds.

Simply put, a tax-free bond is almost similar to a fixed deposit when it comes to investment. A lump sum can be invested in a tax-free bond that carries a fixed rate of interest for a fixed term. On maturity, the principal is returned back to the investor. There is no upcoming tax-free bonds issue in the market, but you may invest in these bonds which are listed on the stock exchanges.

Most tax-free bonds, which have been issued earlier and are now listed on NSE, BSE exchanges, are from government-backed institutions such as Indian Railway Finance Corporation Ltd (IRFC), Power Finance Corporation Ltd (PFC), National Highways Authority of India (NHAI), Housing and Urban Development Corporation Ltd (HUDCO), Rural Electrification Corporation Ltd (REC), NTPC Ltd and Indian Renewable Energy Development Agency. Most of these carry the highest safety ratings as far as receiving interest and principal amount on maturity is concerned.

Features of tax-free bonds

Tax-free bonds have a longer tenure of 10, 15, 20 years. Still, on the exchanges, many of them are available with lesser maturity period as well. And, even though, they are listed on exchanges, the liquidity is low in tax-free bonds, therefore, invest in them only if you are sure that you will not require the funds for such a long period. The interest in these bonds is tax-free and there is no Tax Deducted at Source (TDS) too. Further, they usually offer annual and not monthly interest payouts hence may not meet a retiree’s regular income requirement. If held till maturity, the safety of principal and interest exists.

The face value of a tax-free bond is usually Rs 1000. On the stock exchange depending on interest payment due date or the movement of interest rate in the economy, it can be traded at a discount or premium to its face value. For example, a Rs 1000 bond can be available in the market at Rs 980 or at Rs 1078.

The coupon rate is the fixed rate of interest that the bond carries. It determines how much interest income will be received by the investor. For example, even if an investor has purchased Rs 1000 bond carrying a coupon rate of 8.2 percent per annum interest, at the market price of Rs 1078, the interest payment of Rs 80.20 is received by the investor. But, the investor had purchased the Rs 1000 worth bond at a higher price of Rs 1078. Therefore, the actual yield or return will be lower.

When the purchase price is high, typically the yield will be low compared to the coupon rate. The interest income received based on the coupon rate will, however, be tax-free in the hands of the investor. The maturity date is also an important factor to look at while investing in them. If you wish to sell it before maturity, the gains, if any, will be subject to capital gains tax.

Whom they suit

Tax-free bonds suit investors in the highest tax slab paying 30 percent tax on taxable investments such as bank fixed deposits. For someone paying tax at the highest rate invests in a 6.5 percent taxable deposit such as bank FD, the post-tax rate is about 4.47 percent.

Tax-free bonds are free from the obligation to pay the income tax on the interest income earned. Investors investing in tax-free bonds are not required to pay tax on the half-yearly or annual interest payments and there is no tax liability on the principal amount received on maturity.

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