Tax-Free Bonds: Their Features, Benefits, and How to Invest

What if you could invest, earn a steady income, and pay no tax on it? In India, tax-free bonds make this possible. By investing in tax-free bonds, you essentially lend money to government-backed entities and, in return, earn regular interest income that is fully exempt from income tax. 

In this blog, we will go into the details of tax-free bonds, along with their benefits and features, to assist you in making the right investment decision.

What are Tax-free bonds?

Tax-free bonds are government-issued bonds that provide fixed interest (coupon) payments, which are exempt from income tax, allowing investors to earn tax-free income.

Power Finance Corporation, National Highway Authority of India, Rural Electrification Corporation Ltd., etc.  are some government backed institutions that provide tax-free bonds. This tax-free bond is a debt investment issued for a longer time duration. The main feature lies in the regular interest income, which is entirely tax free according to section 10(15) iv, of the Income Tax Act, 1961. These bonds are primarily issued to fund infrastructure and other developmental projects in India, offering investors a safe and tax-efficient investment option.

Read Also: Benefits of Investing in Bonds

Important Features of Tax-Free Bonds

Important features of the tax-free bonds are listed below:

• Tenure: Tax-Free Bonds are typically issued by government-backed entities, or state governments. They usually have a maturity period of 10 to 20 years. It is most suitable for investors who want to save for retirement or their children’s education.
• Interest Rate: Government issued tax-free bonds pay a fixed minimum of 5.50% and a maximum of 7.50% of the total face value annually. The set interest amount guarantees consistent interest payments during the investment period.
• Tax Benefits: The primary benefit of tax-free bonds is that the income generated from them does not incur tax expenses as long as the interest qualifies for exemption under section 10(15)(iv)(h). Additionally, interest earned on these bonds is exempt from Tax Deducted at Source (TDS).
• Safety: Tax-free bonds are considered low-risk investments. These bonds are ideal for risk-averse investors who prioritize capital protection and ensure reliable returns.

Read Also: What is Coupon Bond?

Sectors that Issue Tax Free Bonds

As we have seen these types of bonds are only issued by government backed companies. Now we will see about the most popular sectors in which tax free bonds are issued:  

1. Power sector: Power generation companies are the ones issuing these bonds, and the amount is used in setting up plants and maintenance related activities. 
2. Railway Infrastructure: Funds are utilised for developing, maintaining, and advancement of the Indian railways infrastructure.
3. Infrastructure Bonds: Issued by infrastructural development companies, to invest in the country’s projects like airports, power generation plants and roads.
4. Public Sector Undertakings Bonds: PSU bonds are issued by government backed companies like HUDCO, REC, NTPC etc. financed for the development of infrastructure, power and housing projects for the country’s growth. 
5. Housing: These bonds are issued by the National Housing Bank to invest in affordable housing projects in districts and states.

Things to Consider before investing in Tax Free Bonds

Various factors to consider before investing in tax free bonds are given below:

1. Interest Rate Risk : Bond prices and interest rates have a negative correlation relationship. The price of older existing bonds (with a lower coupon payment) tend to reduce in value when the market interest rates increase.
2. Liquidity and Exit Options : Tax-free bonds can be listed on the stock exchange, notably the NSE and BSE, but their illiquidity can be an issue.
3. Credit Rating and Safety : While tax-free bonds are typically issued by government-backed entities, it is prudent to verify the bond’s credit rating before making an investment.
4. Yield and Tax Status : Tax-free bonds yield lower rates of interest than bonds that are taxable. For people in high tax brackets, the after-tax yield may be more.
5. New Issues Available : No fresh tax-free bonds have been issued since 2016; investors must now buy them in the secondary market.

Read Also: What are Bond Yields?

Advantages & Disadvantages of Tax-Free Bonds

It is prudent to understand the advantages and disadvantages of an investment before making a decision, and tax-free bonds are no exception. Here is what you need to know:

Advantages 

1. Tax-Free Income : The exemption of tax on interest income earned through tax-free bonds can significantly improve effective returns for bonds, especially for those whose incomes fall under higher tax brackets.
2. Low Risk and High Safety : Government-owned institutions such as the HUDCO (Housing and Urban development corporation limited), NTPC (National Thermal Power Corporation Limited), IREDA (Indian Renewable Energy Development Agency Limited) issue tax-free bonds, making them one of the safest fixed-income options available in India.
3. Predictable and Stable Returns : Bonds provide steady cash flows through guaranteed interest payments at set intervals, making them particularly suitable for retirement planning. Their reliability helps retirees manage expenses and maintain financial stability with minimal risk. 
4. Good for Long-Term Goals : Without the worries of short-term volatility in the financial markets, these bonds make it possible for investors to effectively plan for prominent life milestones due to their long term maturities.
5. Secondary Markets : You can buy or sell tax-free bonds on exchanges.

Disadvantages 

1. Long Investment Period: The most notable disadvantage is the longer maturity tenure that lasts between 10 or 20 years.
2. Lower Coupon Rates Compared to Taxable Bonds: Due to the tax advantage, coupon rates remain lower compared to taxable bonds or corporate debentures. Investors who are not in high tax brackets may find the returns unattractive.
3. Very Few New Issues Available: After 2016, the government ceased the issuance of tax-free bonds. New investment opportunities, therefore, are few and far between. 
4. Not Ideal for Growth Focused Investors: The primary purpose of tax-free bonds is to generate tax-free income. Tax-free bonds provide lower returns compared to equities and other asset classes, making them not suitable for young aggressive investors.
5. Low Market Liquidity: Tax-free bonds can not be easily traded in the market as they are less liquid. 

Read Also: Electoral Bonds Explained: What Are They and Why Did Supreme Court Ban It?

Conclusion

Tax-free bonds can be a suitable investment opportunity for those investors who are looking to earn stable tax free income with minimal risk. Understanding the characteristics and advantages of tax-free bonds enables investors to make decisions which best fit their financial objectives. Always assess your investment time frame, risk level, and liquidity requirements prior to making an investment. Consult a financial advisor before investing.

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