What are Tax-Free Bonds?

Tax-free bonds are a type of debt instrument issued by government-backed entities that offer investors a fixed interest income exempt from income tax. These bonds are particularly attractive to individuals in higher tax brackets, as the interest earned is not subject to taxation, making them a low-risk, tax-efficient investment option. Typically, these bonds have a long tenure, ranging from 10 to 20 years, and are considered a safe investment due to the backing of government entities.

Key Highlights

• Tax-Free Bonds definition-Tax-free bonds are debt instruments issued by the government that yield fixed interest income tax-free, hence are a low-risk and tax-efficient investment, particularly for those who lie in the higher tax brackets.

• These bonds are supported by government agencies, with the majority being as safe as those of the Government of India, offering negligible default risk and having long tenures of at least 10 to 20 years.

• Popular types of tax-free bonds are mainly issued by Infrastructure, Housing, Power, and Public Sector units such as NHAI, PFC, and REC, among others.

• One may invest in tax-free bonds either with a physical certificate or through a Demat account. A subscriber may decide to buy directly in the primary market during the subscription period or trade in the secondary market.

Tax-Free Bonds Meaning

Tax-free bonds are financial instruments where the interest income earned by the investor is completely exempt from taxes under Section 10 of the Income Tax Act, of 1961. Issued by government-backed institutions, these bonds are primarily used to fund infrastructure and development projects. The tax-free status of these bonds makes them especially appealing to high-net-worth individuals and those seeking steady, long-term returns without the burden of additional tax liabilities. Due to their government backing, these bonds also carry a lower credit risk, making them a safer investment compared to other bond types. However, while the interest is tax-free, the principal amount invested is not eligible for any tax deductions.

What are Common Types of Tax-Free Bonds?

The general trend of issuing tax-free bonds in India is normally done by government-backed entities like PSUs, infrastructure companies, and other Government organisations. Following are some of the general kinds of tax-free bonds that could be seen in India:

1. Infrastructure Bonds: This type of bond is issued by infrastructure companies for funding roads, airports, and power plants.

2. Housing Bonds: These types of bonds are issued by government-related entities to raise funds for providing affordable housing.

3. Power Bonds: These types of bonds are issued by power generation companies for financing expansion and maintenance of power plants.

4. Railway Bonds: Issued by Indian Railways, these bonds are for financing expansion and modernisation of the railway network.

5. Public Sector Unit Bonds: The PSU bonds issued by Government-owned companies like National Highways Authority of India, Housing and Urban Development Corporation, National Thermal Power Corporation, Power Finance Corporation, and Rural Electrification Corporation, amongst others for raising finance for projects relating to Infrastructure, Power, and Housing.

Features Of Tax-Free Bonds

Tax-free bonds have some essential features that you should know about:

Tax-Exemption: The interest income from tax-free bonds is exempt from taxes, and there is no applicability of TDS on such bonds. However, one should declare their interest income because the principal amount that is invested in tax-free bonds doesn’t qualify for tax deduction under Section 80C. You can purchase tax-free bonds in either physical form or through a Demat account. Compared to bank FDs, tax-free bonds offer a more tax-efficient return, particularly for investors in the highest income tax brackets.

Risk Factors: The risk of default on both the principal and interest payments is minimal since these bonds are issued on behalf of the government. They also offer capital protection along with a fixed monthly or annual income, making them a relatively safe investment option.

Liquidity: Liquidating tax-free bonds is not as straightforward as liquidating debt mutual funds. Since government bonds are long-term investments with extended lock-in periods, it can be challenging to liquidate tax-free bonds quickly.

Lock-In Tenure: Tax-free bonds come with a longer lock-in period, typically ranging from 10 to 20 years. You cannot withdraw your investment before the maturity date, so it’s important to ensure you won’t need the funds shortly after investing.

Issuance & Transaction: Tax-free bonds can be issued either through a Demat account or in physical form. You can also purchase tax-free bonds from the secondary market if you have short-term financial goals.

Returns: The returns on these bonds largely depend on the purchase price, as they are traded in low volumes with a limited number of buyers and sellers. 

Interest: The interest for tax-free bonds normally ranges between 5.50% and 6.50%. This is quite lucrative since tax is not deducted on such interest income. Generally, the annual interest is payable to the bondholders, but that can also vary in terms of existing yield on Government securities. If invested at current yields, tax-free bonds could return about 6% tax-free return.

Factors To Checklist Before Investing in Tax-Free Bonds

Factors to consider while investing in tax-free bonds are as follows:

Investment objectives: In this respect, the most common investment objective that usually drives people to choose tax-free bonds is a situation where one needs to earn tax-free income, preserve capital, or maintain liquidity.

Investment horizon: Just think about the duration of investment and then match it with your financial goals.

Research: Do thorough research on available tax-free bonds, which may be government and municipal bonds. The rates of interest, credit ratings, and other factors related to your goals of investment should be compared.

Brokerage: Seek the services of a well-reputed stockbroker, customary broker, or online broker who deals in tax-free bond investments.

Open Demat and trading account: Open the Demat and trading account with the selected broker. The entire process might involve an application that has to be filled out along with some personal information.

Buy the bonds: After selecting a tax-free bond, decide on the number of bonds you want to purchase and go ahead with the transaction through your broker.

Risk management: Remember, tax-free bonds do carry credit risk, market risk, and interest rate risk. Note these risks and consult your financial advisor on ways to reduce them.

By keeping all of the above factors in mind, an investor can make a very informed decision while investing in tax-free bonds.

How to Invest in Tax-Free Bonds?

Conversely, if an investor demands the bond after it has been issued, investment takes place through the trading account. Therefore, it is identical to the purchase of shares in a share market. Hence, investments in such bonds are easy to execute and very rewarding. Note: The subscription period for investment is open only for a specific period of time.

You have to fill in your PAN details while opting for the physical format and do your KYC. In case of an issue of bonds to the public by the government, an investor can subscribe by applying online or offline.

Here’s how to invest in tax-free bonds:

1. Provide your PAN details for the physical format.

2. Complete the KYC process.

3. If the government issues bonds to the public, circle one of the following subscription methods:

• Online Application: Apply online via the given platform.
• Offline: Click here for physical application form submission.

On the other hand, if an investor asks for the bond post-issuance, investment is through the trading account. Hence, it is similar to trading shares in a stock market.

How to Redeem Tax-Free Bonds?

Redeeming tax-free bonds is a straightforward process once you have completed the required tenure. However, you cannot redeem your bond before 10-20 years; instead, you may only trade it on stock exchanges with other investors.

Also, the issue cannot buy back the bond. Moreover, the profit made by the selling of the bond is also subjected to taxation under Section 112. Any capital gain made by selling of the bond within a year is charged according to your income tax slab.

In case the bond is traded after one year, it will attract a long-term capital gain tax of 10 per cent, with no benefit of indexation. In a nutshell, tax-free bonds are barely risky securities offering tax-free income.

You can trade these bonds in the secondary market before they mature. However, since 2016, the government has not announced any new issuances of these bonds. Consequently, investors should be mindful of the tenure and interest rate when considering bonds issued by PSU companies.

Who Should Invest in Tax-Free Bonds?

Tax-free bonds are an ideal option for investors seeking fixed income, such as senior citizens. Since government enterprises generally issue these bonds for longer durations, the default risk is minimal, and you can count on a steady income for a prolonged period, usually ten years or more.

The funds raised through these bonds are utilised by government enterprises for investment in infrastructure and housing projects. Tax-free bonds are particularly suitable for investors in the highest tax bracket.

High net-worth individuals (HNI), HUF members, trusts, cooperative banks, and qualified institutional investors are typically inclined to invest in tax-free bonds.

Conclusion

Tax-free bonds are a safe and tax-effective investment for high-net-worth individuals, senior citizens, and those in the higher tax bracket who look for assured, long-term returns. Backed by governmental agencies and authorities, these bonds provide fixed interest income without the incidence of tax, which makes them viable investment instruments for conservative investors. The advantages of tax-free income, low credit risk, and support due to government projects have to be weighed against the extended lock-in period and probable liquidity issues. The investors are expected to do their homework and take advice from financial experts to confirm whether or not the bonds will serve their needs and fall within their risk appetite.

FAQs on Tax-Free Bonds