6 questions on tax-free bonds answered

By Larissa Fernand |  01-03-21 | 

A company may need money for a variety of purposes. It may want to expand its business, build a new plant, buy machinery, buy new land to build a factory, or even purchase another company.

One of the ways to raise money is to issue a bond.

A bond is a debt obligation. The company makes a legal commitment to pay interest on the principal and to return the principal. Whether the company makes profits or incurs losses, or its stock price rises or falls, that is irrelevant to the terms and conditions. It still has to pay the interest rate promised and return the money on the specified date.

So when you buy a bond, you lend money to the company that issued the bond (issuer). In exchange, the company promises to return your money (principal) on a predetermined date (maturity date), and till it does so, it will pay you a specified rate of interest (coupon rate).

Investment adviser Basavaraj Tonagatti looks at tax-free bonds in detail.

1. Who issues tax-free bonds?

Tax-free bonds are offered by public sector companies such as NHAI, NTPC, HUDCO, REC, REL, IREDA, PFC, IRFC and NABARD. They issue bonds for their upcoming infrastructure spending. So when you buy their bonds, you are lending money to these government-held companies, which means safety is assured. Even though these tax-free bonds are offered by state-run companies, do check the ratings.

Bonds are rated by rating agencies. Usually, higher the rating means lower the returns. Lower the rating implies higher risk, so the return is higher to compensate for the risk taken. Do keep one thing in mind that the current rating is not the constant rating. Credit rating companies may change the rating whenever there is an issue with the company’s financial health.

2. What is the tenure of these bonds?

These bonds are long-term holdings, with maturity usually being 10, 15 or 20 years. On maturity, you will get the initial amount invested. But the interest will be directly credited to your bank account annually.

3. What is the tax-impact?

The interest income that you will receive from such bonds will be tax-free. Hence, there is no concept of TDS – tax deducted at source.

However, if you sell the bonds in the secondary market, your transaction will be subject to tax. If the holding period is less than 12 months, capital gains on the sale of tax-free bonds are taxed as per the income slab of the investor. If bonds are held for more than 12 months, the gains are taxed at 10%. 

4. How do I buy tax-free bonds?

If the company issues the bonds, it can be purchased from them (primary market). As of now, there are no such offerings in the primary market. Hence, the only option is to buy them from the secondary market – National Stock Exchange (NSE) or Bombay Stock Exchange (BSE). 

5. Why are such bonds attractive right now? 

Assume you buy a bond issued by a company (primary market).

  • Face Value = Rs 1,000 (how much you pay per bond)
  • Coupon Rate = 8% (interest per annum)
  • Price of the bond = Rs 1,000 (same as face value)
  • Yield = 8% p.a. (Rs 80 on Rs 1,000)

Now assume that interest rates in the economy rise and one can get bonds offering more than 8% p.a. No one will want this bond. So if you want to sell it (secondary market), you will have to make it attractive. So the price of this bond will have to fall.

  • Face Value = Rs 1,000 (stays same)
  • Coupon Rate = 8% (stays same)
  • Price of the bond = Rs 900 (this is how much a buyer will pay)
  • Yield = 8.8% (Rs 80 p.a. on an investment of Rs 900)

If the price of the bond is lesser than the face value, then the yield for holding such bonds will be higher. If the price of the bond is more than the face value, then the yield of holding such bonds will be lesser. 

The falling interest rate scenario makes these bonds attractive. Because they are offering a better return than what is available right now.

The tax-free returns on the current yield of around 6% is attractive. If you take a 6% per annum rate on a fixed deposit, the post-tax returns are even lower. Interest income is taxable as per your tax slab. So for an individual in the 30% tax bracket, the post-tax returns will be 4.2%, and marginally higher at 4.8% for those in the 20% tax slab.

6. Should I invest in such bonds?

Investing in tax-free bonds is beneficial for those in the higher tax bracket. Assume that you fall under the 30% tax bracket, the return of a 6% p.a. tax-free bond is same as that of holding a bank fixed deposit returning 8.5% p.a. before tax. If you fall under the 20% tax bracket, then the equivalent is a 7.5% fixed deposit and under the 10% tax bracket, it amounts to a deposit offering 6.5%.

If you are looking at wealth creation over the long term, this is no substitute for equity. But if you are looking for safe, tax-free, long-term, annual payouts, then this is a good avenue to consider. Being tax free, there is no TDS, as would be the case in a bank fixed deposit.

If interest rates dip more in the future, your bond price will go up. Should you decide to sell it in the secondary market, you will earn more than what you invested. But, if interest rates go up, the demand for your bonds will decrease, along with the price.

Since the maturity is for the long term, buy with caution. Because even though you can sell them in the secondary market, the price you get will depend on the demand from buyers and the interest rate scenario.

Data is as on February 18, 2021. 

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