What are tax-free bonds?

Fixed income securities are everyone’s favourite while safe capital investing is the first preference. Although, they offer lower returns as compared to equity and other risky investment options. Additionally, the return cuts down more due to tax liability levied on it. There comes one fixed-income instrument where the tax liability is negligible, and that is tax-free bond.

This article spotlights tax-free bonds' meaning, their key advantages, and how they work.

What are tax-free bonds?

Tax-free bonds are those fixed-income securities issued by public undertakings which offer tax-free interest income to the Investors The investors earn the pre-fixed interest each year, without incurring any tax obligations on it. Similar to other bonds, they also repay the principal amount on maturity.

Generally, the tax-free bonds in India are issued at a face value. of Rs. 1000. After its issuance, they may trade at discount i.e. at a value lesser than Rs. 1000, or at premium i.e. at a higher value than Rs. 1000 in the secondary market. However, the gain from selling the bonds in the secondary market would attract capital gain tax.

Investors can opt to trade these bonds through a Demat account or physical form. One can apply for these government bonds via online or offline routes. Moreover, the bond issuer cannot repurchase the bond from the secondary market.

The interest rate is fixed based on face value. Even if the price of a bond varies in the secondary market, the interest amount remains the same. For instance, a government enterprise issues a bond at Rs. 1000 with a coupon rate of 8.5%, and after two months of the closing of issuance, the bond is trading at Rs. 1060, the interest income would still be Rs. 85 and not Rs. 90 (8.5% of 1060). The higher the price, the lower would be the return and vice versa. Tenure is also an important factor when investing in tax-free bonds.

If a bondholder chooses to keep the bond till maturity, he/she can redeem these bonds and get repaid the entire principal amount at maturity.

Some of the tax-free bonds in India are the bonds issued by Power Finance Corporation, NTPC Limited, Indian Railways Finance Corporation Limited, Rural Electrification Corporation, National Highways Authority of India, etc.

What are the advantages of the tax-free bond?

One of the key benefits of tax-free bonds is the higher safety of the investment. Since they are issued and backed by government entities, the probability of default of interest payment and principal repayment is pretty low. Despite the minimum risk, the yield offered by such bonds is relatively higher.

Additionally, the interest earned from a tax-free bond is free from tax liability. Neither the tax deducted at source (TDS) applies to these bonds. For the investors who belong to high tax slabs, these bonds are a more suitable investment avenue than other taxable investment options.

Moreover, if a bondholder is willing to liquidate the investment, investors can sell the tax-free bonds in the secondary market through an exchange. An investor can also take a benefit by trading it when the market prices are higher.

How do tax-free bonds work?

The tax-free bonds are issued by those government entities that want to raise funds for certain capital expenditures. The issue remains open for a short period. Investors can subscribe to the issue to purchase these bonds.

Similar to other bonds, these bonds also offer fixed interest as a return for investors. The interest rate is determined based on the prevailing 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). The investors who invest up to Rs. 10 lakh in an issue, are considered retail investors, whereas the investors investing more than Rs. 10 lakh for an issue are qualified as HNIs.

The tax-free bonds usually come with a long tenure of 10, 15, or 20 years. The bondholders can redeem their tax-free bonds at maturity. Investors can also buy and sell these bonds, post-issuance and before maturity, in the secondary market. If the bondholder sells the bond before one year, their profit is taxable as per the income tax slab. If the bondholder sells it after one year, their profit will be levied a long-term capital gain tax of 10%, without any price adjustment benefits.

To wrap up, tax-free bonds keep the investors free from the tax obligations on interest income earned on them. They provide good returns while minimizing the risk. Though, the liquidity of such bonds is lower due to their long tenure. However, the tax-free bonds are more suitable for those investors who prefer less risk and are willing to stay invested for a longer term.