What are tax-free bonds?
Tax-free bonds are a type of fixed income investment where the interest paid to the bondholders is exempt from income tax. These bonds are issued by government entities like government companies, municipal corporations, public sector undertakings, and other infrastructure companies.
Tax-free bonds can act as an effective tax-saving tool for investors. Investors who are looking to maximise their returns and lower their income tax liability may find tax-free bonds useful. In this article, we will discuss the basics of tax-free bonds, their features and how they work.
These bonds have been introduced in India to finance government and infrastructure projects, while also providing an investment option to individuals with a tax-saving benefit. Many states in India issue tax-free bonds for raising capital for infrastructure development.
What are the common types of tax-free bonds?
1. Infrastructure Bonds:
- Issued by infrastructure companies.
- Funds projects like roads, airports, and power plants.
2. Housing Bonds:
- Issued by entities such as the National Housing Bank.
- Finances affordable housing projects.
3. Power Bonds:
- Issued by power generation companies.
- Used for the expansion and maintenance of power plants.
4. Railway Bonds:
- Issued by the Indian Railways.
- Used to finance the expansion and modernization of the railway network.
5. Public Sector Unit Bonds:
- Issued by government-owned companies (e.g., NHAI, HUDCO, NTPC, PFC, REC).
- Funds diverse projects, including infrastructure, power, and housing initiatives.
How do tax-free bonds work?
Investing in tax-free bonds just requires a Demat account, and investors can buy or sell these bonds on the stock exchange. They can also use online trading platforms like the one from Bajaj Financial Securities Limited (BFSL). The interest earned on these bonds is tax-exempt and is directly credited to the investor's bank account.
These bonds listed on the stock exchanges offer flexibility in terms of liquidity. Due to their tax-exempt status, tax-free bonds usually face high demand and low supply, especially during the tax-saving season.
Factors To checklist before investing in tax-free bonds
Here are the factors to consider while investing in tax-free bonds:
- Investment goals: Before investing in tax-free bonds, determine your investment goals, such as earning tax-exempt income, preserving capital, or liquidity.
- Investment horizon: Consider the duration of the investment and match it with your financial goals.
- Research:Thoroughly research the available tax-free bonds, including government bonds and municipal bonds. Compare interest rates, credit ratings, and other relevant factors to suit your investment goals.
- Brokerage: Choose a reputable stockbroker, such as a traditional broker or an online broker, who specialises in tax-free bond investments.
- Open a Demat and trading account: Open a Demat and trading account with the chosen broker. The process may require filling out an application and providing personal information.
- Purchase the bonds: Once you have selected a tax-free bond, decide on the number of bonds you want to purchase and complete the transaction through your broker.
- Risk management: Remember that tax-free bonds are subject to credit risk, market risk, and interest rate risk. Be aware of these risks and consult with a financial advisor on ways to minimise them.
By considering these factors, investors can make an informed decision while investing in tax-free bonds.
Tax-free bonds vs. tax saving fixed deposits
Factors | Tax-Free Bonds | Tax Saving Fixed Deposits |
Investment Tenure | Long-term (10-15 years) | Short-term (usually 5 years or more) |
Tax Benefits | Interest earned is tax-free | Investments are tax-deductible, up to Rs. 1.50 lakh under Section 80C of the Income Tax Act |
Returns | Guaranteed returns | Fixed returns |
Maturity Period | Fixed maturity period | May or may not have a fixed maturity period |
Liquidity | May have lower liquidity | Usually have higher liquidity |
Risk | Considered to be low-risk investments | Considered to be low-risk investments |
Interest Rates | Interest rates are typically lower | Interest rates may be higher |
How to invest in tax-free bonds?
Choose a depository and Demat account:
To invest in tax-free bonds, you need a Demat (Dematerialised) account. You can open one with a depository participant (DP), for example, Bajaj Financial Securities Limited.
Select the appropriate tax-free bonds:
Research and identify the tax-free bonds that match your investment goals and risk tolerance. Different issuers may offer varying interest rates and maturities.
Check your eligibility:
Ensure you meet the eligibility criteria set by the issuer. Typically, individuals, Hindu Undivided Families (HUFs), and Non-Resident Indians (NRIs) are eligible to invest in these bonds.
Apply:
After successfully opening a Demat account, the next step in the process of investing in tax-free bonds is to apply for the specific tax-free bond issue that aligns with your financial goals. This application can be conveniently completed through online platforms of the stockbroking firms.
Transfer funds to your Demat account:
Transfer the investment amount from your bank account to the Demat account.
Allotment:
You will receive a confirmation email or a physical bond certificate, depending on the issuer's process.
Receive periodic interest payments:
Tax-free bonds typically offer semi-annual or annual interest payments. These payments are tax-free, providing you with a regular income stream.
Monitor your investment:
Keep track of your tax-free bond investments in your Demat and trading accounts.
Redeem or trade:
Tax-free bonds have a fixed maturity date. At maturity, you will receive the principal amount back. Alternatively, you can sell your bonds on the stock exchange before maturity if you wish to exit the investment early.
It's essential to conduct thorough research and consult with a financial advisor if needed before investing in tax-free bonds. Each bond issue may have its own unique terms and conditions, so it's crucial to review the specific offering documents provided by the issuer.
Features of tax-free bonds
Some of the features of tax-free bonds include:
- Tax exemption: The interest rate income earned from tax-free bonds is exempt from income tax, making it an attractive investment option for investors looking to minimize their tax liabilities.
- Maturity: Tax-free bonds have a fixed maturity period, generally ranging from 10 to 15 years. Investors can either hold them till maturity or sell them on the exchange.
- Interest rate: Tax-free bonds offer a fixed interest rate, which is usually higher compared to regular fixed income instruments. The interest rate on tax-free bonds can range from 5.50% to 7.50% per annum, depending on the issuer and market conditions.
- Investment cap: The minimum investment in tax-free bonds is usually Rs. 1,000, but it may vary depending on the issuer. At the same time, the maximum investment is usually high, running into lakhs or even crores of rupees, which makes it an ideal investment option for high-net-worth individuals (HNIs).
- Diversification: Tax-free bonds offer a valuable avenue for portfolio diversification. Investors can spread their investments across various sectors and projects, reducing risk by not relying on a single asset class.
- Easy to buy and sell: Tax-free bonds are listed on stock exchanges, ensuring easy accessibility for investors. This listing facilitates straightforward buying and selling transactions, providing liquidity and flexibility to investors.
- Low risk: Tax-free bonds are considered low-risk investments. Issued by government organizations and backed by the government, they provide a high level of security for investors, minimizing the risk associated with fluctuations in the market.
- Liquidity: Tax-free bonds exhibit good liquidity, thanks to their listing on stock exchanges. This feature allows investors to buy or sell these bonds easily, providing a level of flexibility in managing their investment portfolio.
Benefits of tax-free government bonds
The benefits of investing in tax-free bonds include:
- Assured income: Tax-free bonds provide a fixed and assured stream of income, which can be beneficial for investors seeking a predictable cash flow.
- Safety: Tax-free bonds are generally considered to be less risky than other investments since they are backed by government entities, which reduces the risk of default.
- Easy trade: Tax-free bonds are tradable on stock exchanges with a reasonable level of liquidity, making it easy for investors to sell or buy bonds as needed.
- Higher profit for higher tax bracket: Investors in higher tax brackets may benefit significantly from investing in tax-free bonds since the interest earned is not subject to income tax.
Conclusion
Investors should remember that tax-free bonds could be affected by macroeconomic factors and market conditions. While investing in tax-free bonds, investors should consider their investment goals, risk tolerance, and tax implications before making any investment decisions.
Head over to Bajaj Financial Securities Limited (BFSL) for all your investment needs!
