Tax-Free Bonds: How To Invest And Redeem Them?
Bonds are investment instruments issued by corporates and governments to raise funds. Prospective investors receive returns according to a predetermined interest rate for investing their funds. Tax-free bonds do not attract taxes and are lucrative investments for individuals, trusts, HUFs, etc. Read on to get a detailed insight on tax-free bonds and how to invest in them.
What Are Tax-Free Bonds?
These bonds are issued by different public sector undertakings (NHAI, PFC, NABARD, HUDCO, REC, etc.) to raise funds for a specific purpose, for a fixed tenure, and are offered at a predetermined coupon rate. As PSUs issue these, there is a very low credit risk.
Section 10 of the Income Tax Act allows exemption from interest earned on these bonds. These bonds are also traded on stock exchanges. Note that the market price of bonds is crucial as if the interest rate falls, bond prices will rise, and they may trade at a premium with regard to their face value.
How do Tax-Free Bonds Work?
These bonds offer returns to investors at a predetermined coupon rate. All interest earned from these is completely tax-exempt irrespective of the income slab of the investors. The coupon rate that the issuer can offer is dependent on the yield of government securities at that time. The rate does not change during the entire duration of the holding period.
Interest offered is fixed based on two factors: One is the rating of the enterprise issuing the bond, and the other is the status of the investor (whether he/she is a retail investor or a high net worth individual).
Also Read: What Is Dynamic Bond Fund And Is It Worth Investing In?
Features of Tax-Free Bonds
- Risk
The risk associated with these bonds is quite low as they are backed by the government. The chances of default are rare; they can provide stable and decent monthly returns on the capital invested. - Tax exemption
Interest earned on tax-free bonds is completely tax exempt. Moreover, the bonds do not attract any TDS clause, i.e. there is no need on the part of the issuer to deduct tax at the source before crediting interest in the receiver’s bank account. However, the principal amount invested is not applicable for deductions u/s 80C. - Lock-in period
Tax-free bonds come with a fixed lock-in period. It ranges from 10-20 years, and investors cannot withdraw their money before the bond matures. Individuals need to make sure that they do not need the money that they are investing in the near future. However, note that the bonds can be traded on stock exchanges. - Liquidity
The bonds have lower liquidity than other investment instruments. Since these securities come with a fixed lock-in period, investors cannot withdraw their money before maturity. So, liquidating them may be a challenging task. - Issuing authority
Only government-owned companies and municipal corporations can issue these bonds. Investors can acquire these bonds from secondary markets for meeting their financial goals if they are not able to purchase them during the subscription period. - Interest
Investors can earn a guaranteed interest on the bond amount invested annually. Interest rates are influenced by the prevailing rate of government securities. An investor can earn higher interest than a savings account. If one considers the tax-exempt nature, it becomes an efficient investment measure.
Difference between Tax-Free and Tax-Saving Bonds
| Parameter | Tax-Free Bonds | Tax-Saving Bonds |
| Interest | Interest earned is credited every 6 months. The interest rates are also high as compared to other investment instruments. | In the case of tax-saving bonds, interest earned is paid annually to investors. As a result, the rate is slightly lower than tax-free bonds. |
| Tax Exemption | Only the interest is eligible for tax exemption. The investment amount is not deductible under Section 80C. | Initial investment of up to Rs. 20,000 is exempt under Section 80CCF. |
| Suitable for Investment | Tax-free bonds are suitable for individuals and entities that fall under a high tax bracket. | These are suitable for long-term risk-averse investors who aim to save taxes. |
List of Top Tax-Free Bonds in India
Given below is a list of some of the best-performing tax-free bonds in India:
- 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
- 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
How to Invest in Tax-Free Bonds?
Investment in tax-free bonds can be done either offline or online mode by prospective investors. The subscription period is open for a limited time only, and one has to apply within that window to invest in the financial instruments. Individuals or entities going for an offline mode of investment need to complete their KYC with the issuing authority.
Individuals can also acquire these bonds post-issuance through their trading accounts. Investment in them after the issuance is just like share trading.
Who Can Invest in Tax-Free Bonds?
- Investors looking for stable returns over a long period of time can invest in these bonds.
- Individuals having a lump sum amount with them can park their funds.
- These bonds are also suitable for low-risk investors as they are backed by the government.
Furthermore, tax-free bonds for senior citizens may be an efficient investment strategy as they look for stable returns with low risk. However, individuals looking for liquidity in their investment plans can avoid this as it is highly illiquid in nature owing to the lock-in period.
Also Read: Section 54EC: Applicable Exemptions, Capital Assets, And Bonds
Redemption of Tax-Free Bonds
Tax-free bonds have a pre-set maturity period. You can only withdraw the amount after the maturity period is over. However, if you require funds urgently, you can trade them on the bond markets. You need to keep in mind that the entity that issued the bonds will not be able to buy back their bonds.
As per Section 112 of the Income Tax Act, profits earned from the sale of tax-free bonds in the previous year are taxable as per the applicable income tax slab of the seller. This is applicable only if these bonds are sold within a year after purchase.
If you have traded tax-free bonds after 12 months, LTCG (Long Term Capital Gains) will be applicable at a 10% rate without the benefit of indexation.
Final Word
Tax-free bonds are a very popular form of investment. They are useful for keeping one’s tax liability in check. However, one must compare returns, investment duration, and ratings of issuers before taking a plunge.
FAQs on Tax-Free Bonds
Ans: Bonds carry low-risk while stocks are high-risk investment options. When it comes to mutual funds, the risk depends on the type of investment. In many ways, experts consider bonds to be a safer option with secure returns. However, the investment needs are different for different people. So, there isn’t any particular asset class that is perfect for every investor.
Ans: RBI issues these bonds on behalf of the Government of India. They come with a tenure of 7 years and offer interest at the rate of 7.75% per annum. However, they do not offer tax benefits to investors.
Ans: Tax-free bonds are a relatively safe investment option. The government backs these debt instruments. Hence, the chances of default are quite rare. They are suitable for risk-averse investors who are looking to add stability to their portfolio.
Ans: The following are some disadvantages of tax-free bonds:
These bonds have low liquidity as they come with a lock-in period.
Such bonds are prone to interest rate risk
These bonds tend to get oversubscribed quickly, and investors fail to get allotment
Ans: Local governments issue municipal bonds to raise funds for various social welfare purposes. Municipal bodies use such financial instruments to raise funds that are required for building hospitals, schools, and drinking water facilities in their area.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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