Tax Free Bonds

Affluent Capital team believes that conservative investors falling under higher tax brackets can look at the tax-free bonds as a regular stream of income. Investment in tax-free bonds eliminates the reinvestment risks as money remains locked in for a longer period than bank fixed deposits. Reinvestment risks imply the probability of interest rates going lower in the future on bank fixed deposits.

Tax-free bonds, a good bet for risk-averse investors, are expected to hit markets after a gap of one year. The government has already cleared the proposals of the Railways and National Highways Authority of India to issue tax-free bonds.

Salient features of tax free bonds
  • Tax-free bonds are usually issued by government-backed entities to raise long-term funding for infrastructure projects. Credit agencies rate these instruments after assessing the financial health of the entities issuing the bonds.
  • The minimum denomination that these bonds can vary from ₹ 1000 to ₹ 5,000. The maturity period of tax-free bonds is between 10-20 years.
  • The interest on these bonds is typically paid annually. In some cases, the retail investors are offered a slightly higher interest rate than other categories of investors.
  • Tax-free bonds have low default risk because they are issued by government-backed entities.
  • Investments made in tax-free bonds are not eligible for income tax deductions, but interest earned on these bonds is not taxed. Investors can also earn capital gains on these bonds as interest rates are expected to head lower.
  • Tax-free bonds are listed on the stock exchanges, offering an exit route to investors. However, in some cases, they may be thinly traded.
  • Capital gains made on tax-free bonds are taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges is taxed as per the tax slab of the investor, If bonds are held for more than 12 months, the gains are taxed at 10 per cent (or 20 per cent with indexation), whichever is lower.
  • Comparison with fixed deposits: If a tax-free bond carries an interest rate of 8 per cent and the investor falls under the 30 per cent tax slab, the tax-free interest of 8 per cent on these bonds will effectively be 11.50 per cent, before tax. This means the investor will get the same interest as that of a bank deposit which pays 11.50 per cent.