It’s the season of tax-free bonds, or so it looks, going by the series of issues made by companies. So what exactly are these tax-free bonds and do they make for an attractive investment option now?
Tax-free bonds are bonds issued by companies, mostly, government enterprises, on which there is a fixed coupon rate (interest rate) and a long-term maturity of 10,15 or 20 years. As the money is raised for long-term infrastructure projects, these bonds have a long tenure. But given that they are issued by government-backed companies, the credit risk or risk of non-repayment is very low.
Companies such as IRFC, IIFCL, NHAI, REC, PFC, HUDCO, NHB, NTPC and NHPC are allowed to raise tax-free bonds in 2013-14. With the season just starting, REC, HUDCO and IIFCL have so far tapped the market and you may have more issues coming up in succeeding months.
The coupon rate of tax-free bonds are fixed by keeping the prevailing rates of government securities as a reference rate and reducing the same by about 55 basis points for retail investors.
The bonds are available for both residents and NRIs.
What’s tax free?
The term tax-free implies that the interest rate on the instrument is free of tax. That means, the income you receive does not suffer any form of tax. But that’s about it.
These bonds are not to be confused with tax-saving instruments such as NSC or PPF. Tax-free bonds do not receive any deduction under Section 80C or any other provision. The principal does not enjoy any tax deduction nor does it suffer any tax at the time of redemption.
For you as an investor, tax-free bonds fall under the debt asset class and carry a fixed return just like deposits. But often times, investors tend to ignore this option as the coupon rate, on the face of it, may seem lower than other debt alternatives such as bank fixed deposits.
However, it is important for you to know that fixed deposit interest suffers tax, at your income tax slab rate. Hence, the net return for you, post tax, on deposits, is not the actually interest rate quoted but much lower. On the other hand, with a tax-free bond, given that their interest income is tax free, the coupon rate mentioned is actually the net return you get.
See table below to compare a 10-year fixed deposit from a nationalized bank versus the tax-free bond rates currently available. Clearly, for those in the 20% and 30% tax brackets, tax-free bonds turn out to be better options than FDs currently.
These bonds can be bought in physical mode or using your demat account (at FundsIndia, you can buy these bonds as long as you hold a demat account anywhere).
After the initial offer period, they are listed in the stock exchange. But given that they may not enjoy high liquidity in the bourses, you are better off holding these bonds till maturity.
What should be your strategy with these bonds? Tax-free bonds are suitable for investors looking for steady source of income annually and can afford to lock-in their capital for at least 10 years at a stretch. If you do not need the interest income, make sure that you reinvest the interest income in high-yielding debt avenues such as debt mutual funds.
Given that the coupon rates of these bonds are fixed with reference to gilts; the rates are currently attractive as government gilts have high yields at present. This is what makes tax-free bonds attractive now.
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