Every year, around the tax season or the months of January to March, your inboxes get flooded with investment schemes from financial companies offering you some of the best possible methods to save tax or tax free investment options to choose from.
Smart investors pay close attention to these schemes, especially since nearly all interest earning instruments like bank deposits, NSC, corporate deposits etc. are already taxed.
We explain one such investment option – tax-free bonds
Tax free bonds, as the name suggests, are bonds that allow you to invest in them without paying taxes on the interest income earned. These are typically issued by government infrastructure and finance institutions like the National Highways Authority of India, Indian Railways, NABARD, REC, PFC etc. which enjoy a high credit rating and are thus considered less risky.
These bonds carry a fixed coupon rate, which is generally in-line with the current market interest rates and have a longer time to mature, generally 10 years or more. These bonds are listed on both NSE and BSE and get traded.
Who should invest in tax-free bonds?
Tax free bonds are most suitable for investors who seek a fixed annual income with the safety of the principal investment. They should also be willing to lock-in their investment for long periods of time. Individuals falling in high income tax brackets find this an attractive investment option due to absolute income tax benefit.
Interest rates on these bonds vary according to the prevailing interest rate on government securities, generally in the range of 6.5% to 8%. Apart from interest income, which is tax-free, you can also get returns on capital invested, which depends on your buying price of these bonds. The capital gains are, however, not exempt from tax.
How can you invest in tax-free bonds?
You can invest in tax-free bonds at the time of issuance of the bonds, i.e. subscription period, which is typically during the taxation months. You can apply online or offline through a Demat or physical mode with the help of your broker, bank, or financial advisor.
You can also buy an existing tax-free bond from the stock exchanges, after its issuance, just like shares as these bonds are listed and traded.
This is especially relevant during times when interest rates are rising. This is because when they rise, new bonds get issued at higher coupon rates and older bonds fall in price to match the effective yield to maturity for investors. Hence, when you buy from the secondary market, you may end up buying at a lower price thus making profit by way of capital gains.
You must, however, keep in mind that the bonds that you buy cannot be redeemed before the lock-in period but you can sell them again on the exchange.
Thus, tax-free bonds are one of the choicest options, especially for high net-worth individuals who seek to lower their tax liability and invest lump sum amounts without much need to liquidate them for long periods of time.