Tax-free bonds are type of debt instrument issued mostly by quasi-government institution in order raise money from the public and are hence secured unless the government goes bankrupt the Greece way.
In India, tax-free bonds are back after a gap of almost one year as the government in the Union Budget 2015-16 has permitted certain institutions to raise money.
Once listed investors can buy and sell tax-free bonds through the stock exchanges from your trading account. You can also call your broker and place an order or you can buy it yourself if you are trading online.
Read more on how to buy tax free bonds.
National Highways Authority of India (NHAI), Indian Railways Finance Corporation (IRFC), Housing and Urban Development Corporation (HUDCO) Indian Renewable Energy Development Agency (IREDA), Power Finance Corporation Limited (PFC), Rural Electrification Corporation Limited (REC) and NTPC Limited are institutions which have bonds that are scheduled in 2015-16.
Taxation on tax-free bonds
Interest earned on these bonds are tax-free in hands of investor hence the name tax-free bonds. However, capital these bonds are not eligible for exemption from capital gains tax. So, you have purchased the NTPC Tax Free Bond which opens on Sept 23 at a face value of Rs 1000 and sold them at Rs 1050, you have to capital gains on the profit of Rs 50 made from these bonds.
As far as the interest income is concerned one should disclose the same in the income tax return as exempted income.
Redemption of tax-free bonds
Tax-free bonds come with a lock-in period of 10-20 years. However, as these bonds are listed on BSE and NSE a bondholder will be able to sell the same to another person who is interested.
While, selling bonds before maturity may not fetch the required amount and will depend on market conditions.
Capital Gains on tax-free bonds
If the bonds are sold before one year period, the gains will attract capital gains tax as per tax slabs of the individual as explained above. If sold after one year, it will attract 10 per cent of profit with indexation and 20 per cent without indexation.
Read more in indexation table and capital gains calculation here
Who Should invest in tax-free bonds?
Yield on bonds or returns from these bonds is always inversely related with bond price. So, if the bond price trades at a higher level, the yields drop and when the bond prices drop, the yields go higher.
Now let's see how tax free bonds can help individuals in the highest tax bracket. Let's assume you will invest in NTPC Tax-free Bond in Sept 2015, with a coupon rate of 7.53 per cent for a 15-year duration. The post tax returns are 7.53 per cent and effective yield for an investor in 20 per cent tax bracket will be 9.48 per cent and 10.65 per cent for an investor in 30 per cent tax bracket.
Note that any change in the tax rate or tax slab will change the effective yield on the bonds.
Now, let's assume at the same time the maximum one could get on a 5 year fixed deposits is 8 per cent, pre-tax. If you are in the 20 per cent tax bracket, your post-tax yield would be 6.4 per cent, while, in the 30 per cent tax bracket, your post-tax yield would have been 5.6 per cent. Therefore in the 20 and 30 per cent tax bracket, the tax-free bonds make better sense.
Risk averse investor in 20 per cent and 30 per cent tax bracket and who are looking for an alternative to bank fixed deposits or bonds can invest in tax-free bonds as returns post-tax are much higher.