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What Are Tax-free Bonds?

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One of the most important aspects to look into before you choose an investment option is the returns it can deliver. At first glance, the returns from one investment may seem to surpass the returns from another. However, if you only compare gross returns, you may be at a disadvantage. What you really need to look at is the post-tax return rate. Some investments that offer tax free returns or tax exemptions may be better in this regard.  Tax-free bonds in India are a prime example of this type of investment. If you want to earn tax-free returns or benefit from other kinds of tax savings, you can consider adding these bonds to your portfolio. 

Before you do this, however, it’s crucial to understand what tax-free bonds are, their key features, how to apply for tax-free bonds and the other finer details of these securities. 

What are Tax-free Bonds in India? 

Tax-free bonds are debt securities that offer tax-exempt interest payments. To understand this unique benefit, let’s take a closer look at how regular taxable bonds work. These bonds are debt instruments that offer annual coupon payments — also known as interest payments — to investors. 

For example, if you invest Rs. 1 lakh in a 7% bond, you will earn Rs. 7,000 as interest per annum. This interest is added to your total income and taxed at the income tax slab rate applicable to you. So, if the 30% tax slab is applicable to you, your coupon payments will also be taxed at this rate. 

In the case of tax-free bonds, however, the interest is exempt from tax. So, you can earn the annual coupon payments without worrying about increasing your tax burden on account of the additional income. Typically, these bonds are issued by government-backed companies like the Power Finance Corporation, Indian Railways Finance Corporation Limited, NTPC Limited, National Highways Authority of India and the Rural Electrification Corporation. 

Types of Tax-Free Bonds

Infrastructure Bonds

Issued by government-backed entities, infrastructure bonds finance large projects like highways and bridges. They provide tax-free income and attract investors interested in supporting national development.

Housing Bonds

Housing bonds are issued by the National Housing Bank to fund affordable housing projects. They offer tax-exempt interest and contribute to making home ownership more accessible.

Power Bonds

Typically issued by power generation companies, power bonds support the expansion of power plants. Investors earn tax-free returns while enhancing the country's energy capacity.

Railway Bonds

Issued by Indian Railways, these bonds finance railway modernization. They provide tax-free income and are popular among those seeking long-term investment opportunities.

Public Sector Unit Bonds

These bonds are issued by government-owned enterprises to fund various initiatives. They are low-risk investments offering tax-exempt interest, making them attractive for stable financial growth.

Working of Tax-Free Bonds

Tax free bonds are fixed-income securities issued by government-backed entities to finance infrastructure projects. When investors purchase these bonds, they effectively lend money to the issuer, receiving regular interest payments that are exempt from income tax. This feature makes them particularly appealing for those looking to reduce their tax on bonds in india. The principal amount is typically returned at maturity, which usually ranges from 10 to 15 years, providing a reliable income stream.

These bonds are listed on stock exchanges, offering liquidity and the option to buy or sell before maturity. Due to their govt tax free bonds status, these investments often experience high demand, especially during tax planning periods. Investors can benefit from the combination of secure capital and tax-free returns, making them a key component of many tax saving bonds strategies.

Pros & Cons of Tax-Free Bonds

Pros

Cons

Tax Exemption: Interest earned is exempt from income tax, making these bonds an attractive option for individuals looking to reduce their tax burden.

Lower Returns: Compared to some other investment options, tax-free bonds may offer lower interest rates, potentially resulting in lower overall returns.

Low Risk: Issued by government-backed entities, these bonds are considered low-risk investments, providing security to investors.

Long-Term Commitment: Tax-free bonds typically have longer maturities, ranging from 10 to 15 years, which may not suit investors looking for short-term liquidity.

Stable Income: Investors receive regular interest payments, ensuring a predictable cash flow over time.

Market Risk: While generally stable, the market value of these bonds can fluctuate based on interest rate changes, affecting their liquidity.

Diversification: Tax-free bonds can help diversify an investment portfolio, spreading risk across different asset classes.

Investment Minimums: Some tax-free bonds may have high minimum investment amounts, which could limit access for smaller investors.

Examples of Tax-free Bonds in India 

Now that you know what tax-free bonds in India are, let’s take a closer look at some examples of these securities, so you can get more clarity on their characteristics. 

Bond Coupon RateInterest Payment FrequencyBond RatingMaturity DateYield to Maturity (YTM)
8.20% Housing and Urban Development Corporation Limited 20278.20%AnnualCARE AAA StableMarch 5, 20275.08%
7.39% Housing and Urban Development Corporation Limited 20317.39%AnnualCARE AAA StableFebruary 8, 20315.25%
7.38% Rural Electrification Corporation Limited 20277.38%AnnualCARE AAA StableDecember 19. 20275.14%

Key Features and Benefits of Tax-free Bonds 

Tax-free bonds in India have several distinct features that can be beneficial to you if you choose to invest in them. Here is a closer look at these features.

  • Attractive Coupon Rates

Tax-free bonds in India offer attractive interest rates over and above the tax benefits. The interest rates can exceed 7% per annum, which, when combined with the tax exemption, can be an attractive financial proposition for investors. The post-tax returns on these tax-free bonds are essentially the coupon rates, so you can compare the interest rates with the post-tax returns from other assets to get more clarity. 

  • Annual Interest Payouts

Tax-free bonds typically offer annual coupon payments paid out once each year. While this may not be as regular as monthly payouts, they can still be handy in different ways. Since you know with certainty that you will receive this specific sum each year, you can plan your insurance payments or tax payments accordingly and use the coupon payment to meet these recurring annual expenses. 

  • Tax Exemption 

This is, of course, the most defining feature of tax-free bonds in India. The annual coupon payments you receive from these securities are not taxable. In addition to this, there is also no limit on the maximum amount of interest that can be tax-free. So, your entire income in this category will be exempt, making it a highly lucrative investment avenue if you want to enjoy the dual benefits of reduced tax burden and steady income. 

  • Long-Term Investment Outlook

Since tax-free bonds offer the added benefit of tax savings, the maturity period is generally several years. This means your capital will typically be locked in during the entire tenure. Before you invest in tax-free bonds in India, you need to keep this aspect in mind and ensure that you are comfortable with having your funds tied up. It is advisable to avoid investing money you need over the short term in these long-term bonds. 

  • Tradeability

Tax-free bonds may not be as liquid as some other kinds of bonds. However, if you do successfully trade them on the market exchanges, the profit that you earn from the sale will be taxable as long-term capital gains (LTCG) or short-term capital gains (STCG). The tax exemption benefit is only on the coupon payments you receive from the bond. 

Also Read: Long-Term Capital Gain Tax on Property Explained

  • Flexibility of Bond Holdings

Another feature of tax-free bonds in India is the flexibility in holdings. You can hold them in the physical format or the electronic format. For the latter, you will require a demat account. However, it is generally advisable to hold your tax-free bonds in the electronic format since they are easier to transform or redeem this way. 

Tax-free Bonds vs. Tax-saving Bonds

While tax-free bonds offer tax exemption on the coupon payments received, there are other kinds of bonds that offer different tax benefits. These are tax-saving bonds, and the amount you invest in these securities is deductible from your total income, thereby reducing your total taxable income and the resulting tax liability. 

This tax-saving benefit stems from section 80CCF of the Income Tax Act, 1961. You can claim a maximum deduction of Rs. 20,000 during the financial year in which you make the investment. However, keep in mind that for these bonds, the interest is not tax free. Only the principal investment is deductible. 

How to Invest in Tax-free Bonds in India?

Want to know how to apply for tax free bonds in India? The first step is to open a demat account if you want to buy these bonds electronically. Then, you can either purchase tax free bonds in the primary market during a new issue, or you can choose to buy them in the secondary market if they are trading in that segment. 

Even if you opt to buy these bonds in the physical format, it is mandatory to submit the details of your PAN and complete the Know Your Customer (KYC) procedures. 

Authorities that issue the Tax-free bonds?

  • Government Agencies: Various government bodies issue tax-free bonds to fund infrastructure projects, enhancing public facilities and services.

  • Public Sector Undertakings (PSUs): Organizations like the Power Finance Corporation and National Highway Authority of India issue these bonds for development and maintenance projects.

  • Municipal Corporations: Local government entities often issue tax-free bonds to raise funds for urban infrastructure and housing projects.

  • Infrastructure Companies: Private firms engaged in large-scale infrastructure projects also issue tax-free bonds, typically backed by government guarantees.

  • Financial Institutions: Some banks and non-banking financial companies (NBFCs) issue tax-free bonds to attract investments for various projects.

Conclusion

So, now that you know what tax-free bonds in India are and how they work, you can integrate these debt instruments into your tax planning strategy. If you wish to earn tax benefits on the coupon payments, tax-free bonds are ideal. However, if you want tax deductions on the principal invested, tax-saving bonds are suitable. 

What’s more, you can also include both these types of bonds in your portfolio to maximise your tax benefits and reduce your tax burden while earning steady income in the process.

Additional Read: What Are Corporate Bonds?

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Frequently Asked Questions

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Which bonds are considered tax-free?

Answer Field

Tax free bonds are issued by government entities and public sector undertakings (PSUs). The interest earned on these bonds is exempt from income tax, making them a popular choice for investors seeking to reduce their overall tax liabilities.

Are there any tax-free bonds offered by the RBI?

Answer Field

The Reserve Bank of India (RBI) does not directly issue tax free bonds. However, it plays a regulatory role for those bonds issued by government-backed entities and financial institutions, ensuring they comply with relevant regulations.

Are NHAI bonds tax-free?

Answer Field

Yes, bonds issued by the National Highways Authority of India (NHAI) are classified as govt tax free bonds. These bonds provide tax-exempt interest to investors, which makes them an attractive option for long-term investment in infrastructure.

What is the interest rate on IRFC tax-free bonds?

Answer Field

Interest rates on Indian Railway Finance Corporation (IRFC) tax-free bonds typically range from 5.5% to 7.5%, depending on market conditions. These rates are competitive among tax free government bonds, appealing to investors looking for steady returns.

What articles cover income tax on bonds?

Answer Field

Articles on taxation of bonds outline the treatment of interest income from bonds under the Income Tax Act. This includes detailed explanations of how tax free bonds are taxed and the implications for investors.

How do tax-free bonds differ from regular bonds?

Answer Field

Tax free bonds provide tax-exempt interest income, while regular bonds often have taxable interest. This key difference can significantly affect an investor's net returns and overall tax strategy, making tax-free bonds more attractive for tax-conscious investors.

Can I sell tax-free bonds before maturity?

Answer Field

Yes, investors have the option to sell tax free bonds on stock exchanges before their maturity dates. This feature offers liquidity, allowing investors to access their funds without having to wait for the bond to mature.

What are the risks associated with tax-free bonds?

Answer Field

While generally considered low-risk investments, tax saving bonds carry certain risks such as interest rate fluctuations and market volatility. Investors should assess these risks in light of their financial goals and risk tolerance.

Who can invest in tax-free bonds?

Answer Field

Eligibility for investing in tax free bonds india typically includes individuals, Hindu Undivided Families (HUFs), and Non-Resident Indians (NRIs). This broad accessibility makes them a versatile investment option for many types of investors.

How do I find tax-free bonds to invest in?

Answer Field

Investors can find tax free government securities by browsing stock exchanges, consulting financial advisors, or researching online platforms that provide detailed information on available bonds and their features.

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