What are Tax-Free Bonds?
Tax-free Bonds is a category of bonds wherein the coupon (interest) pay outs made to their bondholders are exempt from income tax under Section 10 of the Income Tax Act. These bonds are usually issued by select Public Sector Enterprises and Government Agencies to finance infrastructure or other capital intensive projects having long gestation periods.
Features of Tax-Free Bonds
Tenure: Tax-free bonds are issued with tenures of 10, 15 or 20 years
Frequency Coupon (Interest) payment: The interest payments of these bonds are usually made at annual or half-yearly intervals.
Convertibility: Regulations do not allow tax-free bonds to be converted to equity or preference shares.
Safety: As these bonds are issued by PSUs or Government Agencies, the chances of default are almost nil. However, investors can still refer to the credit ratings assigned to these issuers before investing in their tax savings bonds.
Liquidity: Tax-free bonds are listed on the stock exchanges. Thus, investors seeking to redeem their tax-free bonds before their maturity dates can sell these bonds in the secondary market.
Collateral: Tax-free bonds are usually backed by the assets of the issuing entity. In case of an issuing entity’s liquidation or default by the issuer, the pledged assets can be used to make repayments to the bond holders.
Tax-free income: While the interest income of tax-free is tax-exempt under section 10 of the Income-tax Act, 1961, bond holders can claim this tax benefit only if they register their name and number of bonds held with the bond issuing entity.
Coupon (Interest) Rate: Issuers of tax-free bonds have to factor in Government Security (G-Sec) reference rates while setting their coupon rates. The reference G-Sec rate for a tax-free bond issue would be the average of the G-Sec base yield of equivalent maturity reported by Fixed Income Money Market and Derivative Association of India (FIMMDA) for the two weeks ending on the Friday before the filing of the final prospectus.
Moreover, the coupon rates of tax-free bonds vary for different investor categories subject to the varying ceilings on coupon rates.
In case of bond issuers rated AAA, the ceiling rate would be 50 bps (i.e. 0.50%) lower than the reference G-Sec rate for retail individual investors and 80 bps lower than the reference G-sec rate for Qualified Institutional Buyers, high networth individuals and other customer categories.
For bond issuers rated AA+, the ceiling rate would be 10 bps more than the ceiling rate set for AAA-rated issuers.
For bond issuers rated AA & AA-, the ceiling on coupon rate would be 20 bps more than the ceiling rate set for AAA-rated issuers.
Note that the above-mentioned ceilings on tax-free bond coupon rates are applicable for annual periodicity of interest payments. For tax-free bonds with half-yearly interest payment, the ceiling rates would be 15 bps lower.
Moreover, the higher interest rate offered to retail individual investors would not be applicable once a retail individual investor transfers his tax-free bonds to an investor belonging to another investor category.
Also Know: What are Corporate Bonds?
Eligibility for investing in tax-free bonds
The following investor categories are eligible to invest in tax-free bonds:
- Retail individual investors (including HUFs & NRI — both on repatriation and non-repatriation basis)
- High networth individuals (i.e. retail investors investing more than Rs 10 lakhs during the bond issuance)
- Qualified Institutional Buyers like banks, financial institutions, mutual funds, insurance companies, pension funds, etc
- Corporates including companies, limited liability partnerships, trusts, partnership firms, societies, etc
List of companies allowed to issue tax-free bonds
The Central Government publishes a list of PSUs and Government Agencies, which are eligible to issue tax-free bonds in India. The list is valid for a particular financial year and also states the maximum amount of bond issuances for each eligible entity for that financial year.
Some of the entities authorised to issue tax-free bonds in the past are mentioned below:
- National Highways Authority of India (NHAI)
- Indian Railways Finance Corporation (IRFC)
- National Bank for Agriculture and Rural Development (NABARD)
- Housing and Urban Development Corporation (HUDCO)
- Rural Electrification Corporation Limited (REC)
- NTPC Limited
- Power Finance Corporation Limited (PFC)
- Indian Renewable Energy Development Agency (IREDA)
- NHPC Limited
- IFCI Limited
- National Housing Bank (NHB)
- Cochin Ship Yard Limited (CSL)
- Ennore Port Limited (EPL)
- Indian Infrastructure Finance Company Limited (IIFCL)
Also Check: Bonds vs Fixed Deposit
How to invest in Tax-Free Bonds
Investors can invest in tax-free bonds through the primary market as and when they are open for subscription during their issue period. Investors can use their existing demat accounts to invest in bonds. Investors can also invest in the live bonds, which were issued in the past, through the secondary markets. Such investors would have to use their trading accounts and demat accounts for investing tax-free bonds.