Tax Free Bonds

Tax-free Bonds in India 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. Tax free bonds are usually issued by select Public Sector Enterprises and Government Agencies to finance infrastructure or other capital intensive projects having long gestation periods.

Before investing in tax free bonds in India, check out the key features of tax free bonds in India:

• 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 their 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 bond 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 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:

• 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

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

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.Suggested Read : How to Invest in Bonds for Beginners

Below are the mentioned key benefits of investing in tax free bonds in India which you should consider:

• Tax Free Income: The interest income earned from these bonds are exempt from income tax, helping investors in higher tax brackets retain more of their returns.
• Predictable Income: Tax-free bonds offer fixed coupon payments at regular intervals, providing a reliable source of income.
• Low Risk: Most tax-free bonds are issued by public sector undertakings, which reduces their credit risk, especially when compared with private sector corporate bonds.
• Liquidity: Tax-free bonds are listed on stock exchanges, allowing investors to sell them in the secondary market if they wish to redeem their investment before maturity.

Suggested Read : Sovereign Gold 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.Suggested Read : How NRIs Can Invest in Corporate Bonds

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.

• Interest Rate Risk – If market interest rates rise, the price of existing tax-free bonds in the secondary market may fall, potentially causing capital losses if sold before maturity.
• Liquidity Risk – Although these bonds are listed on NSE and BSE, the secondary market may have limited buyers, making it difficult to sell quickly at a desired price.
• Inflation Risk – Fixed interest returns may not keep pace with inflation over the long term, reducing the real value of your earnings.
• Credit Risk – As capital gains bonds are issued by select credible public sector companies, the chances of default are extremely low. To totally nullify this risk, investors should prefer the tax savings bond having higher credit ratings.

• Conservative investors seeking tax free income with reasonable liquidity.
• Individuals in higher tax brackets would benefit the most from tax-exempt interest income.
• Retirees or senior citizens seeking predictable, tax-efficient interest income.
• Investors who want to diversify their portfolio with government-backed debt instruments.

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.