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.

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 net worth 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 the coupon rates of tax-free bonds 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/her tax-free bonds to an investor belonging to another investor category.

Also Know: What are Corporate Bonds?

The following investor categories are eligible to invest in 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:

Also Check: Bonds vs Fixed Deposit

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 in tax-free bonds.

Check the Credit Rating

While tax-free bonds are issued by PSUs or Government agencies, these bonds too are rated by credit rating agencies like CRISIL, ICRA, etc. PSUs in better financial health are rated higher by these agencies and vice versa. Thus, investors should review the credit ratings of tax free bonds to check whether the issuer’s credit profile aligns with the investor’s risk appetite.

Compare the Bond Yield

The yield offered by tax free bonds in the secondary market can vary depending on their credit rating and maturity profile. As the yield of a bond is a function of its coupon rate and market price, investors should carefully compare the yields for bond selection, instead of just their coupon rates.

Assess the Bond Tenure and Liquidity

Tax-free bonds generally come with maturities of 10, 15 and 20 years. While tax free bonds can be sold in the secondary market, finding buyers at a favorable price can be an issue. This may force you to sell tax free bonds at a loss. Thus, make sure that the tenure of tax free bond aligns with your financial goals and investment horizon.

Understand the Payment Frequency

Tax free bonds usually make coupon payments at half-yearly or annual intervals. Thus, investors should carefully evaluate whether the dates and frequency of their interest payouts match with their income/cash flow requirements.

Tax Treatment

Interest income earned from tax-free bonds is exempt from income tax. However, any profits arising from selling these bonds in the secondary market are subject to capital gains tax, depending on the holding period. Therefore, investors should consider both the tax-free interest income and potential capital gains tax liability before investing.

Differentiation	Tax Free Bonds	Tax Saving Fixed Deposits
Issuer	Only Select Public Sector Companies & Government Agencies are authorised to issue tax free bonds	Banks and Post Office are allowed to open Tax Saving FDs
Tenure	Tax free bonds have tenures of 10, 15 or 20 years	Tax saving fixed deposits have a minimum tenure of 5 years with a mandatory lock-in period of 5 years
Tax Treatment of Interest Income	The interest income is fully exempt from income tax	Interest earned on tax saving FDs is taxed as per the investor’s tax slab
Tax Deduction on Investment Amount	Invested amount cannot be claimed for tax deduction	Invested amount of up to Rs 1.5 lakh per financial year can be claimed for tax deduction under Section 80C
Liquidity	Can be sold in the secondary market before maturity date, subject to the availability of buyers for the quoted price	Can be closed only after the completion of 5 year lock-in period
Investment Window	Tax-free bonds can be purchased from the primary market at the time of bond issuance; post issuance, the bonds can be purchased from the secondary market.	Investors can open tax saving FDs anytime through their bank

Tax Free Bonds are long-term investments with a maturity period of 10, 15 or 20 years. If an investor wants to redeem them before their maturity dates, they can sell these bonds in the secondary market.

Tax-free bonds and tax-saving bonds differ in terms of the tax benefit they provide. The interest income from tax-free bonds is exempt from income tax whereas tax-saving bonds allow investors to claim the investment amount as a deduction for reducing their tax liability. Currently, Section 54EC allows investors to reduce their long capital gains tax liability by investing their long-term capital gains (up to Rs 50 lakh per financial year) derived from property (land and/or building) in capital gain bonds issued by select PSUs. There also used to be a separate category of bonds, called tax savings bonds, which allowed investors to claim the investment amount as a tax deduction. This provision was discontinued in 2005.