Tax Free Bonds Basics

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Tax-free bonds are currently offering a return of 5.75 -6.25% (May 2018) per cent and look like they are back in favour among rich investors. Stable tax free returns and lower volatility compared to debt mutual funds are driving investors back to these bonds, traded only in the secondary markets.
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What are Tax free Bonds

The Indian government backed companies issue these tax-free bonds with a reasonable interest rate. These bonds are of long-term maturity, and the proceeds are usually invested in infrastructure projects. The income that you earn in tax-free bonds in the form of interests is fully exempted from income tax.

The amount that investor invests in buying the bonds is not eligible for any tax deduction. The interest amount which one gets on tax-free bonds is credited directly to the bond holder’s bank account. These tax-free bonds are generally offered by government backed entities. There is no credit or default risk attached to it. So, if any one is looking for a stable source of income, tax-free bonds are the best investment option for them. One can also trade using these tax-free bonds as they are listed on the stock exchanges. However, any capital gain from the sale of these bonds in the secondary market is taxable at 10% without indexation and 20% with indexation benefit.

Normally, the interest is paid out annually. The mode of interest / refund / maturity amounts is done through direct credit, cheques, demand drafts, national electronic clearing scheme (NECS) or real time gross settlement (RTGS).

The Interest Is Lower

The interest rate of tax free bond is fixed slightly lower than the 10 year government bond yield. Because of the tax benefit, the issuer of a tax free bond can afford to give low interest rate. The demand of such tax free bond is more than the supply. Not every entity can issue the tax free bond. The government authorizes some units to issue the tax free bonds. Therefore, these units are in the position to give lower interest rate.

The interest income earned is exempt from tax under Section 10 (15) (iv) (h) of the Income Tax Act, 1961. However, there will be no tax benefit on the amount of investment made in such bonds. There is also no applicability of TDS on interest income.

Limit On Investment

The tax saving option under section 80C are more tax efficient, they give a tax deduction on the investment value as well. But, these investments can’t be more than Rs 1.5 lakh. Therefore, tax free bond is a good option for those who want to deposit a big sum for the long term. There is no upper limit of investment.

However, the Liquidity (saleability) is low. The money gets locked for10-20 years or until you have someone else to buy these off of you. The secondary market is available, but finding a right price may be difficult.

Subscribing to Tax Free Bonds

You can buy tax free bonds through the primary issue as well as from the secondary market.

Like IPO of the shares, there is an issue of tax free bonds. There is no fixed date of this issue. It depends upon the capital requirement of the issuing company and government approval. While an issue of tax free bond comes on the market, you can buy it from the stock brokers and registrar offices. If you buy a bond from the primary market, you will get it at face value. The face value of tax free bonds may be Rs 1000-10,000.

Tax Free Bonds From the Secondary Market

After the primary issue the tax free bonds are listed in the secondary bond market. Like shares, these bonds are also traded daily. You can also buy tax free bonds from the secondary market. To get the tax free bond from the secondary market, you need to take the service of stock brokers. In the secondary market, the price of the bond would determined by the supply and demand. It is more or less than the face value.

Ideal For Large Investment

The main benefit here is that unlike fixed deposits, NSCs and other bonds, the interest earned from these bonds is tax free. Assuming a tax-free coupon yield of 6%, the implied pre-tax rate will be to the tune of ~9% for investors in the 30% tax bracket (those with more than Rs 10 lakh taxable income a year).

Tax-free bonds are therefore ideal for large investment amount and thus are hugely popular with high net worth investors (HNIs) because they allow parking a huge lump sum at one place. They are perceived to be relatively safe as they are primarily issued by government institutions and carry high investment grade ratings. Also, the effective pre-tax yield is high for those in the higher income slab.


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