Tax-Free Bonds: Why & How to Invest?

Benefits of investing in Tax-Free Bonds:

Tax-Free BondsTax-Free Bonds are in huge demand among investors who fall within the upper tax bracket. In a declining interest rate regime, these bonds seem to be a ray of hope for regular income and predictable returns. Tax-free bonds are long-term instruments having an investment tenor of 10, 15 or 20 years.

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Usually there’s vulnerability to default risk in fixed-income investments. Under this, you may suffer a financial loss if the issuer doesn’t pay the periodic interest or fails to repay the principal on maturity. Tax-free bonds are high credit rated securities issued by government-backed entities/corporates. Hence, the default risk is relatively small on these securities.

Also read: Understanding Debt Funds & associated risks

The subscription period for investing in tax-free bonds is open for a limited period within which you need to buy these bonds. These bonds may be issued in both demat form and physical form. However, before maturity, you may freely trade these on a listed stock exchange only if you have purchased them in demat form. Moreover, you need to furnish your Permanent Account Number (PAN), in case you purchase the bonds in the physical format.

The superiority of tax-free bonds as compared to ordinary bonds lies in their being tax-efficient instruments. Unlike ordinary bonds, the interest earned on tax-free bonds is fully exempt from tax under Section 10 of Income Tax Ac 1961. It means that at the time of computation of your tax liability, you will not be required to add the interest income from the tax-free bonds in your total income. However, it does not mean that the interest income can escape your income tax returns. You would still be required to declare the coupon payments received on tax-free bonds in your tax returns.

As regards the principal amount invested in such bonds, you are not entitled to claim it as a tax deduction.

Tax benefit on Tax-free bonds

Although, tax-free bonds may offer comparatively lower coupon payments than ordinary bonds, you usually tend to earn higher after-tax returns as compared to ordinary bonds.

Let me take you through an example.

Computation of Tax on Interest Income on Tax-Free Bonds

Suppose you purchase an ordinary bond and a tax-free bond each having a face value of Rs 1000. For the sake of convenience, let’s assume that both the bonds offer a coupon rate of 10%. Accordingly, the pre-tax coupon payment received from both the bonds would be Rs 80. As the coupon payments are taxable on ordinary bonds, so the post-tax returns come out to be Rs 64 and Rs 54 considering tax brackets of 20% and 30%. On the contrary, the post-tax returns on Tax-free bonds remain Rs 80 for all the tax brackets as the coupon payments are exempt from tax. Hence, tax-free bonds give higher post-tax returns than ordinary bonds.

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Put/Call Option: Advantages & Disadvantages

Tax-free bonds don’t come with a Put/Call Option and have a lock-in period of say 10-20 years.

Put option means that once you buy the bonds, you can ask the issuer to repay the principal before lock-in period gets over. In such a scenario, your money would not remain invested for the entire tenure of the bond. So, you get back your invested principal before the maturity of the bond investment tenure. Call option means the issuer has an option to redeem/buyback the bonds before the expiry of the lock-in period. In such case, the issuer would repay the principal amount outstanding on the bonds. Moreover, its liability to make payment of further coupons would come to an end.

As these bonds don’t have a Call option, it would safeguard you from many kinds of financial risks. Firstly, it would prevent the issuer from redeeming the bonds before maturity. It assures that you will get all the coupons payments which you had envisaged at the time of allotment of bonds. Secondly, you are saved from reinvestment risk. It means the financial loss suffered by the investor when he has to reinvest the principal at a lower interest rate in some alternative haven on account of early redemption of bonds.

Let me explain with the help of an illustration.

You may be aware that bond prices are affected by changes in the interest rate regime. When the interest rates fall in the market, the issuer finds the existing bonds offering a higher coupon rate to be unsustainable. In such a case, he makes use of the call option and redeems the bonds before maturity. Consequently, as an investor, you would have to reinvest your money in some other avenue offering a lower interest rate. Hence, there would be a potential loss of income, and your returns would be reduced substantially.

Redemption of Tax-Free Bonds

Just like equities, bond prices keep fluctuating in the stock markets. When you trade these bonds on a stock exchange, you may earn capital gains on account of appreciation of bond prices. However, unlike interest income, capital gains on the sale of bonds are not exempt from tax. It implies that you would have to include the capital gains earned on tax-free bonds in your total income towards computation of tax liability.

Also read: Capital Gains Tax- the long & short of it

If you sell these bonds within one year from the date of allotment, then capital gains would be taxed as per your income slab. In case the bonds are sold after one year, then the gains would be taxed at 10% (if indexation is not done) and 20% (if indexation is done).

Computation of LTCG tax on Tax-free bonds

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Final Words

Tax-free bonds may be ideal for investors who expect a steady source of annual income in a post-retired life. Being a low-risk and capital preservation investment, tax-free bonds can be used to substantiate your pension income. If you are a high net worth individual who falls in the upper tax bracket and wants to diversify his portfolio, then tax-free bonds may become a perfect companion as a debt instrument.

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